Lecture 6 Investment Appraisal Part A.pptx

FINANCE 2 (FINC 401) Lecture 6: Investment Appraisal Part A Muhammad M. Ma’aji, PhD, A C C A , F M VA Lesson Topic Lesson Plan Time value of money, payback and accounting rate of return Learning Outcomes At the end of this lesson, students will be able to: D...

FINANCE 2 (FINC 401) Lecture 6: Investment Appraisal Part A Muhammad M. Ma’aji, PhD, A C C A , F M VA Lesson Topic Lesson Plan Time value of money, payback and accounting rate of return Learning Outcomes At the end of this lesson, students will be able to: Describe the capital budgeting process and distinguish among the various categories of capital projects; Calculate, interpret, and make investment decisions based on the basic and discounted payback period Calculate accounting rate of return (return on capital employed) and discuss its usefulness as an investment appraisal method. Activities/Methods Lecture, discussion, group exercise, exam practice Reading and References Textbook Reading: Financial Management, 2021, BPP, Chapters 7 Practice: Financial Accounting Revision Kit, 2021, BPP, Questions 34.2, 34.7, 35.4-35.7, 35.9, 36.1-36.10, 37.31, 46, 48 Additional reading: Watson, D. and Head, A. (2016) Corporate Finance Principles and Practice, 7 th Edition, Pearson.  Overview Maximisation of shareholder wealth Investment Financing Dividend decision decision decision Investment decision This can be assessed by payback period and ARR. Neither technique is adequate for making an investment decision and needs to be supplemented by techniques covered in the next chapter. Agenda Introduction to investment decision Accounting Rate of Return (ARR)/ ROCE Payback Period Why Capital Investment? Shareholders provide funds to a firm to invest in real assets. Investments play a vital role in driving growth and expansion for companies. Strategic investments in new products, technologies, markets, or geographic regions can help companies penetrate new markets, reach new customers, and diversify their revenue streams. Well-planned investment decisions can fuel innovation, increase market share, and contribute to long-term success by create value its owners.  What is an Capital Investment/Project Capital investments, also referred to here as capital projects, are investments with a life of one year or longer made by corporate issuers. Companies make capital investments to generate value for their stakeholders by returning long-term benefits and future cash flows greater than the associated funding cost of the capital invested. Put in broader terms, every choice made by a firm can be framed as an investment.  Investment Appraisal Methods  Management uses several criteria to make capital investment decisions. An analyst should understand the economic logic behind each of these investment decision criteria, as well as their strengths and limitations in practice. Non-discount/Basic Methods  Accounting rate of return (ARR)  Payback Period (PBP) Discount Cash-flow (DCF) Methods  Net Present Value (NPV)  Internal rate of Return (IRR)  Profitability Index (PI) Agenda Introduction to investment decision Accounting Rate of Return (ARR)/ ROCE Payback Period Accounting Rate of Return ARR is a financial metric used to evaluate the profitability of an investment or project. ARR calculates the average annual profit or return generated by an investment as a percentage of the initial investment cost. The result of the ARR calculation is expressed as a percentage, representing the average annual return on the initial investment. ARR - Calculation  A project entails an initial investment of $200,000. Over five years net cash flows of $60,000pa are generated. The scrap value of the machine at the end of 5 years is $50,000. Depreciation is on a straight-line basis. Calculate the ARR. ARR - Calculation  Practice 7 A project involves the immediate purchase of an item of plant costing $150,000. It would generate a profit of $8,500 in this first year and expected to increase by 15% in the next four years. The plant purchased would have a scrap value of $20,000 in five years, when the project terminates. The company’s target ARR is 25%. Required Calculate the ARR of the project and advise on its acceptability. Solution  Practice 8 Armcliff Co is a division of Shevin Inc which requires each of its divisions to achieve a rate of return on capital employed (ROCE) of at least 10% pa. For this purpose, capital employed is defined as fixed capital and investment in inventories. This rate of return is also applied as a hurdle rate for new investment projects. Divisions have limited borrowing powers and all capital projects are centrally funded. Armcliff’s production engineers wish to invest in a new computer controlled press. The equipment cost is $14m. The residual value is expected to be $2m after four years operation, when the equipment will be shipped to a customer in South America. The new machine is capable of improving the quality of the existing product and also of producing a higher volume. The firm’s marketing team is confident of selling the increased volume by extending the credit period.  Practice 8 The expected additional sales are: 2020 2,000,000 units 2021 1,800,000 units 2022 1,600,000 units 2023 1,600,000 units Sales volume is expected to fall over time due to emerging competitive pressures. Competition will also necessitate a reduction in price by $0.50 each year from the $5 per unit proposed in the first year. Operating costs are expected to be steady at $1.3 per unit, and overhead by the central finance department is set at $0.85 per unit. Customers at present settle accounts after 90 days on average. Required Determine whether the proposed capital investment is attractive to Armcliff, using ARR method, as defined as average profit‐to‐average investment. Solution Solution ARR – Advantages Simple to calculate Uses profits which may be seen in the financial accounts Gives a percentage measure which may be more readily understood by management. It can be used to compare mutually exclusive projects. ARR – disadvantages Ignores the time value of money Profits are arrived at after taking accruals and provisions into account. It is a relative measure rather than absolute measure. Agenda Introduction to investment decision Accounting Rate of Return (ARR)/ ROCE Payback Period Payback This investment appraisal method calculates the number of years needed to recover the original investment. Measures the time that a project will take to earn the cash that was invested in it. It is based on expected cash flows from the project, not accounting profits. Payback Example Project X Y Z Year $ $ $ 0 (200) (300) (400) 1 150 150 400 2 50 100 - 3 150 100 - 4 - 50 -  Practice 9 A project required an initial investment of $800,000 and then earns net cash inflows of : Year 1 2 3 4 5 6 7 CFs 100 200 400 400 300 200 150 In addition, at the end or the seven-year project the assets initially purchased will be sold for $100,000. Required: calculate the project’s payback period Solution  Practice 10 Guild Co is considering purchasing a new machine. The relevant cash flows are: $ Cost 125,000 Cash inflows: Year 1 35,500 Year 2 45,500 Year 3 52,000 Year 4 27,000 Total 160,000 Calculate the simple payback period of the new machine A 2 years and 6 months B.2 years and 8 months C.2 years and 10 months D.3 years exactly  Discounted Payback Period A project required an initial investment of $800,000 and then earns net cash inflows of : Year 1 2 3 4 5 6 7 CFs 100 200 400 400 300 200 150 In addition, at the end or the seven-year project the assets initially purchased will be sold for $100,000. The cost of capital is 10%. Required: calculate the project’s discounted payback period Year 1 2 3 4 5 6 7 CFs 100 200 400 400 300 200 250 DF10% 0.909 0.826 0.751 0.683 0.621 0.564 0.513 91 165 300 273 186 113 128 Cumu- lative CF (709) (544) (244) 29 157 270 398 Discounted Payback Period = 3 years + (244/273) x 12 months Discounted Payback Period = 3 years + 11 months  Practice 10 Motor Co is considering purchasing new equipment. The relevant cash flows are: $ Cost 85,000 Cash inflows: Year 1 15,000 Year 2 20,000 Year 3 45,000 Year 4 37,000 Total 117,000 Calculate the discounted payback period of the new machine if cost of capital is 10% A 3 years and 2 months B. 3 years and 5 months C. 3 years and 7 months D. 3 years and 10 months Payback - Advantages Simple concept to understand Easy to calculate (provided future cash flows have been calculated) Uses cash, not accounting profit Takes risk into account (in the sense that earlier cash flows are more certain). Payback – Disadvantages Considers cash flows within the payback period only, ignoring size and timing of cash flows. Ignores time value of money (although discounted payback can be used). It does not really take account of risk.  Overview Maximisation of shareholder wealth Investment Financing Dividend decision decision decision Investment decision This can be assessed by payback period and ROCE. Neither technique is adequate for making an investment decision and needs to be supplemented by techniques covered in the next chapter.  Chapter Recap Time value of money, present value of annuity and perpetuity An annuity is a constant cash flow for a number of years. A perpetuity is a constant annual cash flow (an annuity) that will last forever. There are non-discount and discount cash flow (DCF) methods in appraising a project. Management will employ the best investment appraisal techniques available that will give the best return. The payback method and ROCE/ARR/ROI methods of investment appraisal are popular appraisal techniques despite their limitations. Payback is the of time it takes for cash inflows = cash outflow. ROCE is average profit divide through by average investment express as a percentage. Chapter Recap Questions Using Kahoot Thank you for listening Q&A