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2BUS0197 – Financial Management Investment Appraisal Learning outcomes By the end of this session students should appreciate: The main investment appraisal methods The reasons why discounted cash flow methods are preferred Why net present value is regarded as superior to internal rate of return Capital rationing and investment appraisal The role of taxation, inflation, risk and uncertainty on investment decisions The application of sensitivity analysis to investment projects 2 The net present value method Uses discounted cash flows to evaluate capital investment projects A cost of capital or target rate of return is used to discount all cash inflows to their present values The present value of all cash inflows is then compared to the present value of all cash outflows A positive net present value indicates that an investment project is expected to give a return in excess of the cost of capital and will therefore increase shareholder wealth 3 The net present value method where: I0 is the initial investment C1, C2, …, Cn are the project cash flows occurring in years 1, 2, …, n r is the cost of capital or required rate of return N.B. Cash flows occurring during a time period are assumed to occur at the end of that period Decision rule: accept all independent projects with a positive net present value With mutually exclusive projects, select project with highest NPV 4 Example A project costing £1,000 is expected to yield £500 per year for 2 years. Calculate its NPV Year 0 1 2 Cash flow (1,000) 500 500 10% PVF PV 1.000 (1,000) 0.909 455 0.826 413 NPV = (132) Question: Would you accept the project? 5 Pros and cons of NPV method Advantages: Accounts for the time value of money Uses cash flows, not accounting profit Takes into account timing and amount of project cash flows Takes account of all relevant cash flows over the life of a project Disadvantages: Accepting all projects with positive NPV only possible in a perfect capital market Cost of capital may be difficult to find Cost of capital may change over project life, rather than being constant 6 The internal rate of return (IRR) method IRR of an investment project is the cost of capital or required rate of return which, when used to discount the cash flows from a project, produces a net present value of zero where: I0 is the initial investment C1, C2, …, Cn are the project cash flows occurring in years 1, 2, …, n r* is the internal rate of return 7 The internal rate of return (IRR) method The IRR method involves calculating the IRR of a project by linear interpolation and then comparing it with a target rate of return (or hurdle rate) Decision rule: accept all independent investment projects with an IRR greater than the company’s cost of capital or target rate of return 8 Internal rate of return NPV £9,500 0 10% IRR 18% Discount rate £3,000 Investment project _ 9 Estimating the IRR of a project In the previous example, the NPV for r = 18% is negative, while the NPV for r = 10% is positive Hence, the IRR giving a zero NPV falls between 10 and 18%. Using linear interpolation it is possible to estimate the IRR by applying the following formula: 10 Comparing NPV and IRR methods Mutually exclusive projects: If IRR is used, the wrong project may be selected. NPV always gives the correct selection advice + NPV Area of conflict 0 Discount rate IRR of incremental project Cost of capital _ Project B Project A 11 Comparing NPV and IRR methods Non-conventional cash flows: If an investment project has cash flows of different signs in successive periods (i.e. nonconventional cash flows), it may have more than one IRR Applying the IRR method to projects with non-conventional may result in incorrect decisions being taken The NPV method can accommodate non-conventional cash flow, hence it gives the correct selection advice The basic cash flow profiles 12 IRR and NPV with non-conventional cash flows + NPV Cost of capital = RA •Project accepted by IRR method since IRR1> RA and IRR2> RA RB RA Discount rate IRR1 _ •Project rejected by NPV method because NPV0, so accept project •IRR does not offer clear advice since IRR1 < RB < IRR2 13 Comparing NPV and IRR methods Changes in the discount rate: NPV can accommodate changes in the discount rate over the life of an investment project, while IRR ignores them Reinvestment assumptions: NPV method assumes that cash flows from project can be reinvested at a rate equal to the cost of capital. IRR method assumes that cash flows can be reinvested at a rate equal to IRR. NPV reinvestment assumption is realistic 14 The payback method The payback period is the number of years it is expected to take to recover the original investment from the net cash flows resulting from a capital investment project Decision rule: accept a project if its payback period is equal or less than a predetermined target value 15 Example: a simple investment project The above cash flows refer to an investment project that requires a cash investment at the start of the project, followed by a series of cash inflows over the life of the project (conventional project) Question: What is the payback period for the above project? 16 Pros and cons of payback method Advantages: Simple and easy to apply Should not be open to manipulation as it uses cash flows, not accounting profit Accounts for risk as it implicitly assumes that a shorter payback period is superior Disadvantages: Ignores time value of money Does not consider the project as a whole since cash flows outside the payback period are taken into account only out of managerial judgement 17 The return on capital employed method ROCE can be defined as: average annual accounting profit × 100 average investment Where average investment is: (initial investment + scrap value)/2 ROCE can also be defined as: average annual accounting profit × 100 initial investment ROCE is also known as accounting rate of return (ARR) and return on investment (ROI) 18 The return on capital employed method Average annual accounting profit can be calculated from project cash flows by taking off depreciation Accounting profit is not cash flow since depreciation does not correspond to a cash movement Decision rule: accept project if ROCE is equal to or greater than target (or hurdle) rate of return (i.e. current company or division ROCE) If projects are mutually exclusive, the project with the highest ROCE should be selected 19 Example A machine costs £10,000 and its useful economic life is 5 years. After 5 years, the machine’s scrap value is £2,000. The net cash inflows from the machine would be £3,000 per year. Ignore taxation Depreciation: (10,000 – 2,000)/5 = £1,600 Average annual profit: 3,000 – 1,600 = £1,400 Average investment: (10,000 + 2,000)/2 = £6,000 ROCE: (1,400/6,000) × 100 = 23% 20 Pros and cons of ROCE method Advantages: Measured in %, so comparable with company’s ROCE Fairly simple to apply Can be used to compare mutually exclusive projects Considers all cash flows arising during a project’s life, unlike payback method Disadvantages: Uses accounting profit rather than cash Profit not directly linked to primary financial objective of shareholder wealth maximisation Uses average profits and hence ignores timing of profits Ignores time value of money Relative measure and so ignores size of initial investment21 Recap on investment appraisal methods NPV is academically preferred as an investment appraisal method – it has no major defects and is consistent with shareholder wealth maximisation IRR comes a close second and can prove to be a useful alternative ROCE and payback methods are flawed as investment appraisal methods but payback is often used as an initial screening method 22 Capital rationing Arises if a firm has insufficient funds to invest in all projects with positive NPV Hard capital rationing: limitations are externally imposed Soft capital rationing: limitations are internally imposed. Arises if managers Capital Want markets may be depressed Investors may consider the company to be too risky to invest in Issue costs may make a small issue of finance expensive to avoid dilution of control Want to avoid dilution of EPS Wish to avoid fixed interest payments (debt) Wish to follow policy of steady growth Believe restricting available funds will encourage better investment projects 23 Single period rationing Firm must choose combination of projects to maximise total NPV Ranking divisible projects by NPV will not lead to correct decision Divisible projects must be ranked using the profitability index (PI): PI = PV of future cash flows Initial investment 24 Single period rationing For indivisible projects, selection must be made by looking at total NPVs of possible combinations of projects The combination with highest NPV, which does not exceed capital rationing limit will be optimal investment schedule The investment of surplus funds is not relevant to the investment decision 25 Multi-period period rationing Profitability index and NPV evaluation of project combinations do not help Linear programming must be used to determine the optimum combination Simple problems can be solved by hand, complex problems by computer 26 Relevant project cash flows Relevant cash flows are incremental cash flows arising from an investment decision, such as initial investment, cash from sales and direct costs Usually exclude: Sunk costs – incurred prior to the project start, hence not relevant to project appraisal (e.g. market research) Apportioned fixed costs – excluded from project evaluation as are incurred regardless of whether a project is undertaken (e.g. rent) Usually include: Opportunity costs – if an asset is used for a project, relevant to know what benefit has been foregone Incremental working capital – increase in working capital will be a cash outflow for the company relevant for the project appraisal 27 Optimising capital investment decisions The investment appraisal process must account for: The effects of taxation and inflation on project cash flows The required rate of return The risk and uncertainty to which future cash flows are subject 28 Taxation Tax relief on capital expenditure is given through capital allowances In the UK: 25% reducing balance capital allowances given on plant and machinery 100%, 50% and 40% first-year allowances have been offered for specific investments In the last year of an investment project a balancing allowance is needed in addition to a capital allowance to ensure that the capital value consumed by the firm over the project’s life has been deducted in full in calculating taxable profits 29 Taxation Tax liability arises on taxable profits Tax relief is available on allowable costs, such as materials, wages and maintenance Interest payments are not relevant cash flows as these are included in the discount rate After-tax cash flows must be discounted with a relevant after-tax cost of capital Timing of tax liabilities and benefits should be considered 30 Inflation Inflation can adversely affect capital investment decisions by reducing the real value of future cash flows and increasing their uncertainty Future cash flows must be adjusted to take into account any expected inflation The real cost of capital is found from the nominal (or money) cost of capital by making an adjustment for inflation: (1 + n) = (1 + r) × (1 + i) (1 + i) hence (1 + r) = (1 + n) 31 Risk and uncertainty Risk refers to a set of unique circumstances, which can be assigned probabilities Uncertainty implies probabilities cannot be assigned to different sets of circumstances In practice, the terms ‘risk’ and ‘uncertainty’ are often used interchangeably The business risk of an investment increases with the variability of returns Uncertainty increases with project life 32 Sensitivity analysis A method of evaluating project risk by examining how responsive the NPV of a project is to changes in the variables from which it has been calculated Only one variable is changed at a time (i.e. variables assumed to be independent) Two methods to measure sensitivity: Change variables by a set amount then recalculating the NPV Finding the change in a variable which gives a zero NPV Both methods give indication of the key variables of an investment project, i.e. small changes in these variables can have a significant adverse effect on the project 33 Problems with sensitivity analysis Only one variable at a time can be changed No indication is given of the probability of changes in key project variables Not really a method of analysing project risk, since probabilities are ignored 34 Summary Today we looked at: Investment appraisal methods Comparison between NPV and IRR methods Relevant project cash flows Optimisation of capital investment decisions Taxation Inflation Risk and uncertainty Sensitivity analysis 35 Readings Textbook Watson D. and Head A., (2007), Corporate Finance Principles and Practice, 5th (4th) edition, FT Prentice Hall, Chapters 6 and 7 Research paper Arnold, G. C., Hatzopoulos, P. D. (2000), The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business Finance & Accounting, Vol. 27, 5, pp. 603-626 Barwise, P., Marsh, P. R., Wensley, R. (1989), Must Finance and Strategy Clash?, Harvard Business Review, September- October, pp. 85-90 Phelan, S. E. (1997), Exposing the illusion of confidence in financial analysis, Management Decision, Vol. 35, 2, pp. 163-168 36 Your tutorial activities for next week During the seminar you will be expected to work on: Q2 p.187; Q1 p.220 (5th ed) Q2 p.179; Q2 p.206 (4th ed) To prepare for the seminar you should answer the following practice questions: EQL - UFM4 Textbook - Q4 p.183; Q5 p.185; Q3 p218 (5 th ed) Q4 p.176; Q5 p.178; Q4 p205 (4th ed) 37 [...]... initial investment2 1 Recap on investment appraisal methods NPV is academically preferred as an investment appraisal method – it has no major defects and is consistent with shareholder wealth maximisation IRR comes a close second and can prove to be a useful alternative ROCE and payback methods are flawed as investment appraisal methods but payback is often used as an initial screening method 22 Capital... economic life is 5 years After 5 years, the machine’s scrap value is 2, 000 The net cash inflows from the machine would be £3,000 per year Ignore taxation Depreciation: (10,000 – 2, 000)/5 = £1,600 Average annual profit: 3,000 – 1,600 = £1,400 Average investment: (10,000 + 2, 000) /2 = £6,000 ROCE: (1,400/6,000) × 100 = 23 % 20 Pros and cons of ROCE method Advantages: Measured in %, so comparable... relevant for the project appraisal 27 Optimising capital investment decisions The investment appraisal process must account for: The effects of taxation and inflation on project cash flows The required rate of return The risk and uncertainty to which future cash flows are subject 28 Taxation Tax relief on capital expenditure is given through capital allowances In the UK: 25 % reducing balance... employed method ROCE can be defined as: average annual accounting profit × 100 average investment Where average investment is: (initial investment + scrap value) /2 ROCE can also be defined as: average annual accounting profit × 100 initial investment ROCE is also known as accounting rate of return (ARR) and return on investment (ROI) 18 The return on capital employed method Average annual accounting... rationing limit will be optimal investment schedule The investment of surplus funds is not relevant to the investment decision 25 Multi-period period rationing Profitability index and NPV evaluation of project combinations do not help Linear programming must be used to determine the optimum combination Simple problems can be solved by hand, complex problems by computer 26 Relevant project cash flows... IRR1> RA and IRR2> RA RB RA Discount rate IRR1 _ •Project rejected by NPV method because NPV0, so accept project •IRR does not offer clear advice since IRR1 < RB < IRR2 13 Comparing NPV and IRR methods Changes in the discount rate: NPV can accommodate changes in the discount rate over the life of an investment project, while IRR ignores them Reinvestment assumptions:... rate equal to IRR NPV reinvestment assumption is realistic 14 The payback method The payback period is the number of years it is expected to take to recover the original investment from the net cash flows resulting from a capital investment project Decision rule: accept a project if its payback period is equal or less than a predetermined target value 15 Example: a simple investment project The... restricting available funds will encourage better investment projects 23 Single period rationing Firm must choose combination of projects to maximise total NPV Ranking divisible projects by NPV will not lead to correct decision Divisible projects must be ranked using the profitability index (PI): PI = PV of future cash flows Initial investment 24 Single period rationing For indivisible projects,... Investment appraisal methods Comparison between NPV and IRR methods Relevant project cash flows Optimisation of capital investment decisions Taxation Inflation Risk and uncertainty Sensitivity analysis 35 Readings Textbook Watson D and Head A., (20 07), Corporate Finance Principles and Practice, 5th (4th) edition, FT Prentice Hall, Chapters 6 and 7 Research paper Arnold, G C., Hatzopoulos, P D (20 00),... 100%, 50% and 40% first-year allowances have been offered for specific investments In the last year of an investment project a balancing allowance is needed in addition to a capital allowance to ensure that the capital value consumed by the firm over the project’s life has been deducted in full in calculating taxable profits 29 Taxation Tax liability arises on taxable profits Tax relief is available ... Management Decision, Vol 35, 2, pp 16 3-1 68 36 Your tutorial activities for next week During the seminar you will be expected to work on: Q2 p.187; Q1 p .22 0 (5th ed) Q2 p.179; Q2 p .20 6 (4th ed) To prepare... Relative measure and so ignores size of initial investment2 1 Recap on investment appraisal methods NPV is academically preferred as an investment appraisal method – it has no major defects and... exceed capital rationing limit will be optimal investment schedule The investment of surplus funds is not relevant to the investment decision 25 Multi-period period rationing Profitability index