Capital Budgeting 2 Dr. Clive Vlieland-Boddy

Investment Appraisal

A means of assessing whether an investment project is worthwhile or not 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

Investment Appraisal Types of investment appraisal: Payback Period Accounting Rate of Return (ARR) Internal Rate of Return (IRR) Profitability Index Net Present Value (NPV) (or discounted cash flow) What factors need to be considered before investing in equipment such as this?

Payback Method e.g. –Cost of machine = £600,000 –Annual income streams from investment = £255,000 per year Payback = 36 x 600,000/765,000 –= months –(2 yrs, 6¾ months) Income Year 1255,000 Year 2255,000 Year 3255,000

Payback Remember this is just a simple calculation of how quickly the investment is returned. Does not consider the time value of money Does not consider after payback returns.

Accounting Rate of Return A comparison of the profit generated by the investment with the cost of the investment Average annual return or annual profit ARR = __________________________________ Initial cost of investment

Net Present Value Takes into account the fact that money values change with time How much would you need to invest today to earn x amount in x years time? Value of money is affected by interest rates NPV helps to take these factors into consideration Shows you what your investment would have earned in an alternative investment regime

Time Value of Money

Example With Mutually Exclusive Projects PeriodProject A Project B IRR19.43%22.17% NPV The required return for both projects is 10% being the WACC. Which project should you accept and why?

Decision Criteria Positive NPV. Highest IRR. Where conflict use NPV.

Discounted Cash Flow An example A firm is deciding on investing in an energy efficiency system. Two possible options are under investigation One yields quicker results in terms of energy savings than the other but the second may be more efficient later Which should the firm invest in?

The actual cash flows in blue show the amount paid or received. The white is the value in present day terms

There are many tools available on the internet Many also use spread sheets. The main difficulty is establishing the actual expected cash flows Discounting them is just applying the PV factor and adding up the PV values.

Discounted Cash Flow – Option A YearCash Flow (£)Discount Factor (4.75%) Present Value (£) (CF x DF) , , , , , , , , , , , , , ,544 Total 285,000 NPV =139,417

Discounted Cash Flow – Option B YearCash Flow (£)Discount Factor (4.75%) Present Value (£) (CF x DF) , , , , , , , , , , , , , ,634 Total285,000 NPV = 108,802

Decision Criteria The one with the highest NPV. Look at payback as an alternative!

Discounted Cash Flow System A represents the better investment System B yields the same return after six years but the returns of System A occur faster and are worth more to the firm than returns occurring in future years even though those returns are greater

The Final Exam This could well have a DCF of two projects or options. The marks are mainly on applying the tools in establishing the investment decision. There may well be errors in establishing the cash flows but do not worry.

Internal Rate of Return Allows the risk associated with an investment project to be assessed The IRR is the rate of interest (or discount rate) that makes the net present value = to zero –Helps measure the worth of an investment –Allows the firm to assess whether an investment in the machine, etc. would yield a better return based on internal standards of return –Allows comparison of projects with different initial outlays –Set the cash flows to different discount rates –Software or simple graphing allows the IRR to be found

Profitability index (PI) Also known as profit investment ratio (PIR) and value investment ratio (VIR) Is the ratio of payoff to investment of a proposed project. It is a useful tool for ranking projects because it allows you to quantify the amount of value created per unit of investment.

What is the PI? Profitability index is an investment appraisal technique calculated by dividing the present value of future cash flows of a project by the initial investment required for the project. It returns to a ratio/% which management tend to understand better than a NPV!

The Ratio The Ratio is:

Example of PI A project with an initial investment of $1 million, and present value of future cash flows of $1.2 million Would have a profitability index of 1.2. Based on the profitability index rule, the project would proceed.

Probability Index Rules for selection or rejection of a project: If PI > 1 then accept the project If PI < 1 then reject the project For example, given: Investment = $40,000 Life of the Machine = 5 Years

NPV Vs PI Profitability index is actually a modification of the net present value method. While present value is an absolute measure (i.e. it gives as the total dollar figure for a project). The profitability index is a relative measure (i.e. it gives as the figure as a ratio).

Calculate NPV at 10% and PI: Year CFAT PV Total present value (-) Investment NPV 3679 PI = 43679/40000 = > 1 ⇒ Accept the project

Investment Appraisal Key considerations for firms in considering use: –Ease of use/degree of simplicity required –Degree of accuracy required –Extent to which future cash flows can be measured accurately –Extent to which future interest rate movements can be factored in and predicted –Necessity of factoring in effects of inflation

Capital Budgeting In Practice We should consider several investment criteria when making decisions NPV and IRR are the most commonly used primary investment criteria Payback is a commonly used secondary investment criteria as it is easily understood.

Summary – DCF Criteria Net present value –Difference between market value and cost –Take the project if the NPV is positive –Preferred decision criterion Internal rate of return –Discount rate that makes NPV = 0 –Take the project if the IRR is greater than the required return –Same decision as NPV with conventional cash flows –IRR is unreliable with non-conventional cash flows or mutually exclusive projects Profitability Index –Benefit-cost ratio –Take investment if PI > 1 –Cannot be used to rank mutually exclusive projects –May be used to rank projects in the presence of capital rationing

Summary – Payback Criteria Payback period –Length of time until initial investment is recovered –Take the project if it pays back in some specified period –Doesn’t account for time value of money and there is an arbitrary cutoff period Discounted payback period –Length of time until initial investment is recovered on a discounted basis –Take the project if it pays back in some specified period –There is an arbitrary cutoff period

Summary – Accounting Criterion Average Accounting Return –Measure of accounting profit relative to book value –Similar to return on assets measure –Take the investment if the AAR exceeds some specified return level –Serious problems and should not be used

Quick Quiz Consider an investment that costs $100,000 and has a cash inflow of $25,000 every year for 5 years. The required return is 9%. –What is the payback period? –What is the NPV? –What is the IRR? –Should we accept the project? What decision rule should be the primary decision method? When is the IRR rule unreliable?

36 Bye for now! I’m ready for some leisure time. Please ensure you Prepare for next session

37 The End