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Capital Investment Appraisal

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Title: Capital Investment Appraisal


1
Chapter 14
  • Capital Investment Appraisal

2
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.

3
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.

4
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.

5
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.

6
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.

7
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.

8
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
9
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.

10
Net cash flow
Net cash flow operating cash flows / -
capital cash flows
11
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
12
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.

13
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.
14
Example 14.1 Accounting rate of return
15
Example 14.1 Accounting rate of return
16
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.
17
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.

18
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.

19
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 managements concern to be
    reimbursed on the initial outlay as soon as
    possible.
  • It is not concerned with overall profitability or
    the level of profitability.

20
Example 14.2 Payback
21
Example 14.2 Payback
22
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.
23
Advantages of payback
  • It is simple to understand and apply.
  • It promotes a policy of caution in investment.

24
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.

25
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).

26
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
    companys cost of capital.

27
Example 14.3 Cost of capital
28
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 100,000 x 9 9,000
  • Equity 50,000 x 12 6,000
    150,000
    15,000
  • Thus the WACC is 10 (15,000 ? 150,000 x 100).

29
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.

30
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.

31
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.

32
Example 14.4 Net present value
33
Example 14.4 Net present value
34
Accept or reject criteria for NPV method
Accept the project Reject the project
NPV is positive. In choosing between mutually exclusive projects, accept the project with the highest NPV. NPV is negative.
35
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.

36
Disadvantages of NPV
  • It is not as easily understood as the payback and
    accounting rate of return.
  • It requires knowledge of the companys cost of
    capital, which is difficult to calculate.

37
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.

38
The internal rate of return (IRR)
39
The internal rate of return (IRR)
40
Example 14.5 Internal rate of return
41
Example 14.5 Internal rate of return
42
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.
43
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.

44
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 IRRs 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.

45
Appraisal methods
Accounting Rate of Return (ARR)
Profits
Non time based
Payback
Cash flows
Net Present Value (NPV)
Cash flows
Time based (DCF)
Cash flows
Internal Rate of Return (IRR)
46
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.

47
Appraisal methods
Newport Leisure Park Ltd investment appraisal
summary
48
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.

49
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.

50
Example 14.6 Project appraisal with unequal
lives
51
Example 14.6 Project appraisal with unequal
lives
52
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.

53
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

54
Example 14.7 Calculation of cash flows
55
Example 14.7 Calculation of cash flows
56
Example 14.7 Calculation of cash flows
57
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.

58
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.

59
Discounted payback
Newport Leisure Park Ltd. discounted payback
60
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.

61
Illustration 14.1 Sensitivity analysis
62
Illustration 14.1 Sensitivity analysis
63
Illustration 14.1 Sensitivity analysis
64
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.

65
Illustration 14.2 Calculation of expected values
66
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.

67
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.
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