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Chapter 14

- Capital Investment Appraisal

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.

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.

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.

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.

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.

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.

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

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.

Net cash flow

Net cash flow operating cash flows / -

capital cash flows

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

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.

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.

Example 14.1 Accounting rate of return

Example 14.1 Accounting rate of return

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.

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.

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.

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.

Example 14.2 Payback

Example 14.2 Payback

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.

Advantages of payback

- It is simple to understand and apply.
- It promotes a policy of caution in investment.

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.

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).

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.

Example 14.3 Cost of capital

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).

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.

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.

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.

Example 14.4 Net present value

Example 14.4 Net present value

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.

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.

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.

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.

The internal rate of return (IRR)

The internal rate of return (IRR)

Example 14.5 Internal rate of return

Example 14.5 Internal rate of return

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.

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.

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.

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)

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.

Appraisal methods

Newport Leisure Park Ltd investment appraisal

summary

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.

Comparing mutually exclusive projects with

unequal lives

- Calculate the NPV of each project.
- 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. - Compare the EAA of each project, accepting the

project with the highest equivalent annual

annuity.

Example 14.6 Project appraisal with unequal

lives

Example 14.6 Project appraisal with unequal

lives

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.

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

Example 14.7 Calculation of cash flows

Example 14.7 Calculation of cash flows

Example 14.7 Calculation of cash flows

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.

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.

Discounted payback

Newport Leisure Park Ltd. discounted payback

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.

Illustration 14.1 Sensitivity analysis

Illustration 14.1 Sensitivity analysis

Illustration 14.1 Sensitivity analysis

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.

Illustration 14.2 Calculation of expected values

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.

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.