Investment Appraisal PDF

 A means of assessing whether an investment project is worthwhile or not  Can help decide which investment opportunity is better for the firm  Quantitive & Qualititive techniques  Investment project could be the purchase of a new PC for a small firm, a new piece of equip...

 A means of assessing whether an investment project is worthwhile or not  Can help decide which investment opportunity is better for the firm  Quantitive & Qualititive techniques  Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc  Used in both public and private sector Hinges on 3 main factors  Firms objectives  Opportunities it faces  Constraints it works within  Why do companies invest? ◦ Importance of remembering investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank!  Buy equipment/machinery or build new plant to: ◦ Increase capacity (amount that can be produced) which means:  Demand can be met and this generates sales revenue  Increased efficiency and productivity  Investment therefore assumes that the investment will yield future income streams  Investment appraisal is all about assessing these income streams against the cost of the investment  Not a precise science! A fork lift may be an important item but what does it contribute to overall sales? How long and how much work would it have to do to repay its initial cost? Copyright: Loisjune, stock.xchng  Investment Appraisal is the use of scientific decision-making tools to analyse whether a proposed future investment should go ahead.  There are 3 techniques that all involve a comparison of the cost of investment project with the expected return in the future.  Payback The time taken to recover the initial cost of the investment.  Average Rate of Return (ARR) The profits earned on investment expressed as a % of the cost of initial investment.  Net Present Value (NPV) The total returns from an investment in today’s terms.  Payback measures the time it will take to payback the initial cost of the investment.  This includes calculating the year and month in which it will be paid back.  Payback is the most commonly used by businesses due to its simplicity. However, rarely used on its own.  Very important to a business with cash flow problems  Also if the business is investing in equipment that may become out-of-date quickly.  May be important if the business is run on external sources of finance. Year Cash out Cash in Net Cash Flow  A company plans to buy a 0 new machine costing £500,000  It will bring in new revenues 1 of £100,000 the following year and then £150,000 for 2 each of the following four years.  There will maintenance costs 3 of ◦ Year 3: £20,000 ◦ Year 4: £30,000 4 ◦ Year 5: £50,000  How long will it take to repay 5 the initial investment? Year Cash out Cash in Net Cash Flow  A company plans to buy a 0 £500,000 0 (£500,000) new machine costing £500,000 1 £0 £100,000 £100,000  It will bring in new revenues of £100,000 the following year and then £150,000 for 2 £0 £150,000 £150,000 each of the next four years.  There will be maintenance 3 £20,000 £150,000 £130,000 costs of ◦ Year 3: £20,000 4 £30,000 £150,000 £120,000 ◦ Year 4: £30,000 ◦ Year 5: £50,000  How long will it take to repay 5 £50,000 £150,000 £100,000 the initial investment? Year Cash out Cash in Net Cash We determine the payback period by Flow calculating the cumulative next cash flow 0 £500,000 0 (£500,000) until the initial outlay is paid off. 1 £0 £100,000 £100,000 YEAR 1 £100,000 2 £0 £150,000 £150,000 YEAR 1 + YEAR 2 £100,000 + £150,000 = £250,000 3 £20,000 £150,000 £130,000 YEAR 1 + YEAR 2 + YEAR 3 £100,000 + £150,000 = £130,000 = £380,000 4 £30,000 £150,000 £120,000 YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4 £100,000 + £150,000 + £130,000 + £120,000 = £500,000 5 £50,000 £150,000 £110,000 Investment of £500,000 is paid back in year 4  Most payback problems require you to calculate the specific month of payback as well as the year.  How do we do this? Year Cash out Cash in Net Cash Step 1: Find the year of payback Flow Add up net cash flows year by year 0 £750,000 0 (£750,000) until the cumulative net cash flow exceeds the initial investment 1 £7,500 £150,000 £142,500 YEAR 1 £142,500 2 £7,500 £200,000 £192,500 YEAR 1 + YEAR 2 £142,500 + £192,500 = £335,000 3 £7,500 £260,000 £252,500 YEAR 1 + YEAR 2 + YEAR 3 £142,500 + £192,500 + £252,500 = £587,500 4 £7,500 £260,000 £252,500 YEAR 1 + YEAR 2 + YEAR 3 + YEAR 4 £142,500 + £192,500 + £252,500 + £252,500 = £840,000 5 £7,500 £300,000 £292,000 Since the investment of £750,000 is more than the cumulative net cash flow in year 3 but less than in year 4, we know that the investment is paid back sometime in Year 4. On to step 2… Year Cash out Cash in Net Cash Flow Step 2: Find the month of payback which the investment is paid back 0 £750,000 0 (£750,000) a) Calculate remaining cash required £750,000 - £587,500 = £162,500 1 £7,500 £150,000 £142,500 At end of year 3 b) Divide remaining cash required 2 £7,500 £200,000 £192,500 by net cash flow for that year and multiply by 12 3 £7,500 £260,000 £252,500 £162,500 = 0.644 x 12 = 7.728 £252,500 4 £7,500 £260,000 £252,500 months 5 £7,500 £300,000 £292,000 c) Round up to next month d) Add back the number of years Payback period is 3 years and 8 months  The shorter the payback period the less risk there is involved in the project and the quicker the business start to generate profit from the investment.  Doesn’t take into account the business’ profitability.  Doesn’t take into account additional cash inflow after the payback period  Assumes steady inflows throughout the year. Exam Help: Try and think of payback in relation to the business, such as expected lifespan of the project, seasonality and cash flow situation. Year Cash out Cash in Net Cash Flow How long (Year & 0 £310,000 (£310,000) Month) will it take to repay the initial 1 £15,000 £125,000 £110,000 investment? 2 £15,000 £127,000 £112,000 3 £15,000 £140,000 £125,000 4 £15,000 £140,000 £125,000 5 £15,000 £130,000 £115,000  Assesses the value of an investment by calculating the average annual profit as a percentage of the initial investment cost.  Potential projects can be compared  Takes into account all the cash flow throughout the whole life of the project.  Focuses on key factor : PROFIT  Average annual profit x 100 Initial investment Average Total net cash flow annual = profit Number of years* * The “life” of the asset Year Cash out Cash in Net Cash Flow Step 1: Calculate average annual net profit 0 £750,000 0 (£750,000) Total net 1 £7,500 £150,000 £142,500 cash flow £382,500 = = £76,500 5 Life of the 2 £7,500 £200,000 £192,500 asset 3 £7,500 £260,000 £252,500 Step 2: Divide average annual profit by the initial investment and multiply by 100 4 £7,500 £260,000 £252,500 £76,500 X 100 = 10.2% 5 £7,500 £300,000 £292,500 £750,000 1,132,500-750,000 = £382,500  The higher the ARR the potentially profitable the investment.  Allows easy comparison to other forms of investment like bank interest rates.  Doesn’t take timing of the cash flow into account 1.Calculate ARR period for Machine B 2. Compare Machine B to Machine A, which is the best investment? 17.9%  Takes into account the total return from an investment in today’s terms.  This is done using the DISCOUNT FACTOR The rate by which future cash flows are reduced to reflect the current interest rates.  Higher the rate if interest, and the longer the time before you receive the money = less your money is worth in today’s term!  Can base interest rate on: ◦ Current rate ◦ Expected rate in years to come ◦ Own firms criteria e.g. wants all investments to generate at least 15%  Used in NPV & IRR  1 Discount Factor = ----------------- (1 + i)n Where i = interest rate n = number of years  The PV of £1 @ 10% in 1 years time is 0.9090  If you invested 0.9090p today and the interest rate was 10% you would have £1 in a year’s time  Process referred to as: ‘Discounting Cash Flow’  An another advantage of NPV is that is takes into account the time value of money  This is the recognition of the fact that £1 today is worth more than £1 in the future.  Suppose I have £10 today and I put that money in the bank for two years at an interest rate 10%. How much will I end up with in 2019?  £10 x 1.1 x 1.1 = £12.10  This is compound interest.  A shorter formula for compound interest is (1+i)n  (1+0.1)2= 1.1  How would I find out how much £12.10 in two years’ time is worth today?  In effect, it is the reciprocal of the compound interest formula  And is known as the discount factor:  = £12.10 x 1÷ (1+0.1)2 = £10.00  = £12.10 x 0.826446 = £10.00 Year Cash out Cash in Net Cash Flow Discount NPV factor 0 750,000 (750,000) 1.00 (750,000) 1 7,500 150,000 142,500 0.91 129,675 2 7,500 200,000 192,500 0.83 159,775 3 7,500 260,000 252,500 0.75 189,375 4 7,500 260,000 252,500 0.68 171,700 5 7,500 300,000 292,500 0.62 181,350 Net present value 81,875 ASSIGNMENT  Machine A  Machine B  If POSITIVE value then the project is profitable and is therefore WORTHWHILE  If NEGATIVE value then the project is considered unprofitable and will be REJECTED  Takes account of whole life of the investment  Takes into account net cash flows for whole period  Takes account of the time value of money  Takes account of the opportunity cost of the project  Quite complex and technical – not easily understood by non-financial managers  Often inaccurate discount factor over time  Payback ◦ Cowell or Cole? 0 5  ARR ◦ Cowell or Cole? 0 5  NPV ◦ Cowell or Cole? 0 5  Sum to invest  Source of funds  Impact on rest of business  Ability to reverse decision  Impact of investment of future plans  Market stability – extent of change  Competitor reactions  Economic environment  Accuracy of cash flow projections  Projected life of investment decision  Aims and objectives of the business  Image- effect on reputation and brand  Personnel: work habits, morale, culture etc.  Consumer perceptions  Effect on communities  Production issues  Cultural issues