Capital investment decisions

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CapitalCapital InvestmentInvestmentDecisionsDecisions SessionSession SummarySummary (1)(1)learning objectiveswhat is an investmentthe five main investment appraisal criteria methodsaccounting rate of return (ARR)paybackkey principles underlying investment selection criteria SessionSession SummarySummary (2)(2)discounted paybackfuture values of £100 using a discount rate of5% per annumdiscounted cash flow (DCF)net present value (NPV)internal rate of return (IRR)interpolation of the internal rate of return (IRR)extrapolation of the internal rate of return (IRR) SessionSession SummarySummary (3)(3)advantages and disadvantages of the five investmentappraisal methodsother factors affecting investment decisionsrisk and uncertainty and decision-making – sensitivityanalysisproject appraisal factors used in sensitivity analysiscontrol of capital investment projects LearningLearning ObjectivesObjectives (1)(1)explain what is meant by an investmentoutline the key principles underlying investmentselection criteriaoutline the strengths and weaknesses of the fiveinvestment appraisal criteriaexplain what is meant by discounted cash flow (DCF)consider investment selection using the appraisalcriteria of net present value (NPV) and internal rateof return (IRR) LearningLearning ObjectivesObjectives (2)(2)explain the effects of inflation, working capitalrequirements, length and timing of projects, taxation, andrisk and uncertainty on investment criteria calculationsevaluate the impact of risk and the use of sensitivityanalysis in decision-makingconsider the ways in which capital projects may becontrolled and reviewedappreciate the importance of the project post-completionaudit WhatWhat isis anan Investment?Investment?an investment requires expenditure on something todaythat is expected to provide a benefit in the futurethe decision to make an investment is extremely importantbecause it impliesthe expectation that expenditure today willgenerate future cash gainsin real termsthat greatly exceed the funds spent today TheThe FiveFive MainMain InvestmentInvestmentAppraisalAppraisal CriteriaCriteria MethodsMethods AccountingAccounting RateRate ofof ReturnReturn(ARR)(ARR) ARR = average accounting profit over the project x 100%initial investment PaybackPaybackthe number of years it takes the cash inflows from acapital investment project to equal the cash outflows KeyKey PrinciplesPrinciples UnderlyingUnderlyingInvestmentInvestment SelectionSelection CriteriaCriteria(1)(1) CASH IS KING real funds flows can be seen in cash but not in accountingprofit interest charges become payable as soon as money ismade available, for example, from a lender to a borrower,not when an agreement is made or a contract is signed  KeyKey PrinciplesPrinciples UnderlyingUnderlyingInvestmentInvestment SelectionSelection CriteriaCriteria(2)(2)  TIME VALUE OF MONEY receipt of £100 today has greater value than receipt of£100 in one years time there are two reasons for this   KeyKey PrinciplesPrinciples UnderlyingUnderlyingInvestmentInvestment SelectionSelection CriteriaCriteria(3)(3)  reason 1 money could have been alternatively invested in say riskfree Government gilt-edged securitiesthe actual rate of interest that will have to be paidwill be higher than the Government rate, toinclude a risk premium - neither companies norindividuals are risk-free borrowers KeyKey PrinciplesPrinciples UnderlyingUnderlyingInvestmentInvestment SelectionSelection CriteriaCriteria(4)(4)reason 2purchasing power will have been lost over a year due toinflation generally, the higher the risk of the investment, thehigher the return the investor will expect from it   FutureFuture ValuesValues ofof £100£100 usingusing aaDiscountDiscount RateRate ofof 5%5% PerPerAnnumAnnum DiscountedDiscounted CashCash FlowFlow (DCF)(DCF)the principles underlying the investment appraisaltechniques that use the DCF method are cash flow(as opposed to profit), and the time value of moneyof the five main criteria used to appraise investments,net present value (NPV), internal rate of return (IRR),and discounted payback are discounted cash flow (DCF)techniquesthe technique of discounted cash flow discounts theprojected net cash flows of a capital project to ascertainits present value, using an appropriate discount rate, orcost of capital NetNet PresentPresent ValueValue (NPV)(NPV)NPV is today’s value of the difference between cashinflows and outflows projected at future dates,attributable to capital investments or long-term projects InternalInternal RateRate ofof ReturnReturn (IRR)(IRR)the IRR calculates the exact rate of return that a projectis expected to achieve, which is the discount rate usedthat results in a zero net present value (NPV) of thedifference between cash inflows and outflows InterpolationInterpolation ofof thetheInternalInternal RateRate ofof ReturnReturn (IRR)(IRR) ExtrapolationExtrapolation ofof thetheInternalInternal RateRate ofof ReturnReturn (IRR)(IRR) DiscountedDiscounted PaybackPaybackthe discounted payback method requires a discount rateto be chosen to calculate the present values of cash flowsand then the payback is the number of years required torepay the original investment AdvantagesAdvantages andand DisadvantagesDisadvantages ofof thetheFiveFive InvestmentInvestment AppraisalAppraisal MethodsMethods OtherOther FactorsFactors AffectingAffectingInvestmentInvestment DecisionsDecisionsAdditional factors impacting on investment criteriacalculations are:the effect of inflation on the cost of capitalworking capital requirementslength of projecttaxationrisk and uncertainty RiskRisk andand UncertaintyUncertainty andandDecision-MakingDecision-Making–– SensitivitySensitivity AnalysisAnalysis (1)(1)There may be a number of risks associated with each ofthe variables included in a capital investment appraisaldecision:estimates of initial costsuncertainty about the timing and values of future cashrevenues and coststhe length of projectvariations in the discount rate RiskRisk andand UncertaintyUncertainty andandDecision-MakingDecision-Making–– SensitivitySensitivity AnalysisAnalysis (2)(2)sensitivity analysis may be used to assess the riskassociated with a capital investment project ProjectProject AppraisalAppraisal FactorsFactors UsedUsedinin SensitivitySensitivity AnalysisAnalysis ControlControl ofofCapitalCapital InvestmentInvestment ProjectsProjectsTo establish the appropriate levels of control, and toensure that projects run to plan the following areabsolute essentialsthe appointment of a good project manager with theappropriate level of responsibility and authorityregular project reviews [...]... repay the original investment Advantages Advantages and and Disadvantages Disadvantages of of the the Five Five Investment Investment Appraisal Appraisal Methods Methods Other Other Factors Factors Affecting Affecting Investment Investment Decisions Decisions Additional factors impacting on investment criteria calculations are: the effect of inflation on the cost of capital working capital requirements... Sensitivity Analysis Analysis (2) (2) sensitivity analysis may be used to assess the risk associated with a capital investment project Project Project Appraisal Appraisal Factors Factors Used Used in in Sensitivity Sensitivity Analysis Analysis Control Control of of Capital Capital Investment Investment Projects Projects To establish the appropriate levels of control, and to ensure that projects run to... Underlying Investment Investment Selection Selection Criteria Criteria (1) (1)   CASH IS KING   real funds flows can be seen in cash but not in accounting profit   interest charges become payable as soon as money is made available, for example, from a lender to a borrower, not when an agreement is made or a contract is signed   Key Key Principles Principles Underlying Underlying Investment Investment... cash flows of a capital project to ascertain its present value, using an appropriate discount rate, or cost of capital Net Net Present Present Value Value (NPV) (NPV) NPV is today’s value of the difference between cash inflows and outflows projected at future dates, attributable to capital investments or long-term projects Internal Internal Rate Rate of of Return Return (IRR) (IRR) the IRR calculates... neither companies nor individuals are risk-free borrowers Key Key Principles Principles Underlying Underlying Investment Investment Selection Selection Criteria Criteria (4) (4) reason 2 purchasing power will have been lost over a year due to inflation   generally, the higher the risk of the investment, the higher the return the investor will expect from it     Future Future Values Values of of £100... a capital investment appraisal decision: estimates of initial costs uncertainty about the timing and values of future cash revenues and costs the length of project variations in the discount rate Risk Risk and and Uncertainty Uncertainty and and Decision-Making Decision-Making –– Sensitivity Sensitivity Analysis Analysis (2) (2) sensitivity analysis may be used to assess the risk associated with a capital. .. underlying the investment appraisal techniques that use the DCF method are cash flow (as opposed to profit), and the time value of money of the five main criteria used to appraise investments, net present value (NPV), internal rate of return (IRR), and discounted payback are discounted cash flow (DCF) techniques the technique of discounted cash flow discounts the projected net cash flows of a capital project... (2)     TIME VALUE OF MONEY   receipt of £100 today has greater value than receipt of £100 in one years time   there are two reasons for this     Key Key Principles Principles Underlying Underlying Investment Investment Selection Selection Criteria Criteria (3) (3)     reason 1   money could have been alternatively invested in say riskfree Government gilt-edged securities the actual rate of interest that ... Affecting Affecting Investment Investment Decisions Decisions Additional factors impacting on investment criteria calculations are: the effect of inflation on the cost of capital working capital requirements... a capital investment project Project Project Appraisal Appraisal Factors Factors Used Used in in Sensitivity Sensitivity Analysis Analysis Control Control of of Capital Capital Investment Investment... initial investment Payback Payback the number of years it takes the cash inflows from a capital investment project to equal the cash outflows Key Key Principles Principles Underlying Underlying Investment
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