1 Capital investment appraisal

2 Introduction As investments involve large resources, wrong investment decisions are very expensive to correct Managers are responsible for comparing and evaluating alternative projects so as to allocate limited resources and maximize the firm’s wealth Basic techniques of making capital investment appraisal for evaluating proposed capital investment projects

3 Investment appraisal methods Considering the time value of money concept Ignoring the time value of money concept Net present value Internal rate of return Payback period Accounting rate of return

4 Net present value method

5 Time value of money When facing different investment proposals, the management should choose the project that can generate the greatest addition of value to the company. For example, Project AProject B Initial investment$100$100 Cash inflow at end of year Year 1$110 Year 2$121

6 At first sight, some may think that project B is better because it has a higher cash inflow. However, the time value of money concept states that a dollar today is always worth more than a dollar in the future The two projects are of equal value to the company because their present values are the same

7 After taking timing of cash flow into consideration, Project AProject B Present value of cash flow (interest rate is 10% per annum) (1+10%)(1+10%) 2 = $100$100 The two projects are of equal value to the company because their present values are the same

8 Factors leading to the changes in value of money Opportunity cost of money Erosion of purchasing power due to inflation Uncertainty and risk

9 Opportunity cost of money Opportunity cost of money refers to the cost incurred or income forgone by not using the money for other purpose For surplus cash, the opportunity cost is the interest income forgone by investing the cash in other investments or depositing it in the bank

10 Erosion of purchasing power due to inflation Inflation refers to the continual increase in the general price level of goods or services During a period of inflation, prices of goods increase while the purchasing power of money decrease. The purchasing power of a dollar today is greater than that of the future

11 Uncertainty and risk Investors tend to avoid risk. The uncertainty involved in future cash inflows is much higher than that in present cash inflows If the level of risk rises, investors will expect a higher return as compensation. For example, suppose an investor expects $100 for return now. After adding a 10% risk premium, he will expect $110 one year later

12 Discounting

13 Discounting According to the time value of money concept, a dollar in one year is not worth the same as a dollar in anther year. In evaluating a multi-year investment, cash inflows and outflows are generated in different years It is necessary to convert the cash flows for different years into a common value at a common point of time, either at present or in the future

14 Discounting is the process of reducing future cash flows to present values with the use of an interest rate Present value = FV n (1+r) n Where FV = Future value of an investment n= Number of years r= Appropriate interest rate

15 Example

16 John has won a lucky draw. He is deciding whether to receive the Prize money of $3000 today or the following set of cash flows over the next three years: YearCash flow 1$1100 2$1210 3$1331 Future valuesDiscount processesPresent value Year 1$1100$1100/1.1$1000 Year 2$1210$1210/1.1 2 $1000 Year 3$1331$1331/1.1 3 $1000

17 Net present value method

18 Net present value method Net present value (NPV) method is a process that uses the discounted cash flow of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return With the NPV method, we can compare the return on investment in capital projects with the return on an alternative equal risk investment in securities traded in financial market

19 Calculation procedures 1. Determining the discount rate 2. Calculating the NPV: NPV = FV 1 FV 2 FV 3 FV n (1+r) 1 (1+r) 2 (1+r) 3 (1+r) n I 0 where FV = future value of an investment n = no. of years r = Rate of return available on an equivalent risk security in the financial market I 0 = initial investment

20 3. Interpreting the NPV derived as follows: NPVsCommentsReasons <0Reject the project The rate of return from the project is small than the rate of return from an equivalent risk investment =0Indifferent to accept or reject the project The rate of return from the project is equal to the rate of return from an equivalent risk investment >0Accept the project The rate of return from the project is greater than the rate of return from an equivalent risk investment HighestAccept the project If various project are considered, the project with highest positive NPV should be chosen

21 Example

22 A company is considering making several investments in the Production facilities for the new products with an estimated useful Life of four years. The cash inflows and outflows are listed as follows: Project ABCD $$$$ Initial investment Cash inflow Year Year Year Year The appropriate discount rate of these investment is 12%

23 Required: (a)Calculate the NPV of each investment and determine whether to accept it or not (assuming the company has unlimited resources) (b)If the company has limited resources, determine which investment should be accepted by referring to the highest NPV

24 Project A NPV = = $ (accepting) Project B NPV = = $214920(accepting) (a)

25 Project C NPV = = $0 (indifferent to accept or reject) Project D NPV = = -$135801(rejecting) (a) (b) With limited resources, the company should only accept project A because it generates the highest NPV

26 Advantages of NPV Consistency with the time value of money concept Consideration of all cash flows Adoption of cash flows instead of accounting profit

27 Internal rate of return

28 Internal rate of return The internal rate of return is the annual percentage return achieved by a project, of which the sum of discounted cash inflow over the life of the project is equal to the sum of discounted cash outflows If the IRR is used to determine the NPV of a project, the NPV will be zero. The company will accept this project only if the IRR is equal to or higher than the minimum rate of return or the cost of capital

29 Calculation procedures 1. By trial and error, find out the discount rate that will give a zero NPV where FV = future value of an investment n = no. of years r = internal rate of return I 0 = initial investment 2. If the NPV is positive, try a higher discount rate in order to give a negative NPV and vice versa NPV = FV 1 FV 2 FV 3 FV n (1+r) 1 (1+r) 2 (1+r) 3 (1+r) n I 0 = 0

30 3. After getting one positive NPV and one negative NPV, use interpolation to find out the rate giving zero NPV IRR = L + P P – N (H – L) Where L = Discount rate of the low trial H = Discount rate of the high trial P = NPV of cash flows of the low trial N = NPV of cash flows of the high trial

31 4. In evaluating an investment project, the IRR is compared with the management’s predetermined rate IRRsCommentsReasons < lowest acceptable level of returnRejectNPV<0 = lowest acceptable level of returnAcceptNPV=0 > Lowest accepted level of returnAcceptNPV>0 HighestAcceptIf several project are considered, the highest IRR should be chosen

32 Example

33 A project costs $400 and produces a regular cash inflow of $200 at the end of each of the next three years. Calculate the IRR. If the minimum rate of return is 15 %, suggest with reason whether you Should accept the project or not. NPV = $200 $200 $200 (1+r) 1 (1+r) 2 (1+r) $400= 0 NPV = $200 $200 $ $400= 8.4 Assuming the discount rate is 22% NPV = $200 $200 $ $400= -3.8 Assuming the discount rate is 24%

34 IRR = L + P P – N (H – L) Where L = Discount rate of the low trial H = Discount rate of the high trial P = NPV of cash flows of the low trial N = NPV of cash flows of the high trial IRR = 22% – (-3.8) (24 – 22)% = 23.38% Since the IRR (23.38%) is higher than the minimum rate of return (15%), The project should be accepted

35 Payback period

36 Payback period Payback period is the period of time it takes for a company to recover its initial investment in a project The method measures the time required for a project’s cash flow to equalize the initial investment

37 Acceptance criterion < predetermined cutoff periodAccept the project > Predetermined cutoff periodReject the project

38 Example

39 A company is considering making the following mutually exclusive Investments in the production facilities for the new products with an Estimated useful life of four years. The cash inflow and outflows are Listed as follows: Project AProject B$ Initial investment Cash inflow at the end of year Year Year Year Year Project A : 3 yearsProject B: 2 years Project B takes only two years to recover its initial investment. With The shortest payback period, the company will accept project B

40 Advantages of payback period Easy to adopt Facilities further evaluation After obtaining an acceptable payback period, the project will be evaluated by other financial capital budgeting techniques

41 Disadvantages of Payback period Ignore the cash flows after payback period Adopt an arbitrary standard for the payback period Ignores the timing of cash flow

42 Discounted payback period The payback period method is criticized for ignoring the timing of cash flows, therefore discounted cash flows are used to calculate the discounted payback period

43 Example

44 A company is considering making the following mutually exclusive investments in the production facilities for the new products with an estimated useful life of four years. The cash inflow and outflows are listed as follows: Project AProject B Initial investment Cash inflow at the end of year Year Year Year Year Discount cash inflow (20%)

45 Project AProject B$ Initial investment Discounted cash flow Year Year Year Year Discount payback period Project A = = = 3.3 years Project B = 2.96 years = 69444= = = = =

46 Accounting rate of return

47 Accounting rate of return The accounting rate of return compares the average accounting profit with the average investment cost of project The accounting profit can be expressed either before tax or after tax

48 Calculation procedures ARR = Average net profit per year (over the life of the project) Average investment cost Average net profit per year = Total profit No. of life of the project Average investment cost = Initial investment 2

49 In evaluating an investment project, the ARR of the project is compared with a predetermined minimum acceptable accounting Rate of return: ARRsComments < minimum acceptable rateReject project = minimum acceptable rateAccept project > minimum acceptable rateAccept project HighestChoose highest ARR Acceptance criterion

50 Example

51 A company is considering whether to buy specialized machines For a new production line. The purchase price of machinery is $ and its estimated useful life is four years. There is no scrap Value after four years The project income statements: Year1Year 2Year 3Year 4 $$$$ Revenue Depreciation Other expenses Profit before tax Taxation (15%) Should the company buy the new machinery if the minimum acceptable Rate of return is 20%?

52 Average net income = = $63750 Average investment = = $ The cost of machinery is $ at the beginning The cost of machinery is $0 at the end as depreciation is provided On straight line method and there is no scrap value ARR = $63750 $ = % Since the ARR is %, which is higher than the minimum Acceptable rate of 20%, the company should invest in the new machinery.

53 Advantages of ARR It is easy to understand and compute It avoids using gross figures. Therefore, it enables comparisons to be made between projects with different useful lives

54 Disadvantages of ARR It ignores the time value of money ARR method seems to be less reliable than the NPV method. It adopts the accounting profit instead of cash flows calculation. The change of depreciation method may also alter the accounting profit