FDM11 Capital investment apprasal 3 Capital investment appraisal 3

FDM11 Capital investment apprasal 3 Capital investment appraisal 3 Estimating the cost of capital Dealing with inflation Risk and capital investment The management process Reading: IFAC guide Project Appraisal using DCF (see mycourse)

FDM11 Capital investment apprasal 3 Estimating the cost of capital Return required by projects based on opportunity cost of capital Most companies have mix of debt and equity (share capital) Debt and equity have different costs Base cost of capital on weighted average based on proportions of debt and equity

FDM11 Capital investment apprasal 3 Weighted average cost of capital WACC = (proportion of debt × cost of debt) + (proportion of equity × cost of equity) Where cost of debt = interest rate for debt Cost of equity return required by investors –based on analysis of shares traded in stock markets Choose projects which give return greater than WACC

FDM11 Capital investment apprasal 3 Time value of money – a reminder Money now is worth more than the same money later Interest Inflation Risk, uncertainty

FDM11 Capital investment apprasal 3 Inflation Over time, leads to loss of purchasing power Investors need to be compensated –Market interest rates generally take inflation into account Can allow for inflation in cash flow and cost of capital –As long as inflation is included in both

FDM11 Capital investment apprasal 3 Risk Important aspect of financial decision making Key in capital investment decisions: –Long timescales mean more can change –Size of investment – impact of changes can be significant Need to assess risks before making decisions Must manage risks when implementing projects May also allow for risk in calculations

FDM11 Capital investment apprasal 3 Assessing risks Sensitivity analysis –How might returns vary with changes in specific factors? –How much could they change before the decision changes? Scenario planning –Look at several factors at once Use expected values – estimate expected NPV Payback period as indicator of risk

FDM11 Capital investment apprasal 3 Accounting for risk in calculations Relationship between risk and return –Investors demand higher return for higher risk investments Increase discount rate to reflect risk premium –Risk-adjusted discount rate (NPV) or hurdle rate (IRR) Base adjustment on assessment of risk –For specific projects –For categories of projects

FDM11 Capital investment apprasal 3 Setting a discount rate Start point opportunity cost of capital Discount rate must then be calculated separately Add premium to reflect risk of investment May use different rate for specific projects or categories of project –Require higher return for higher risk investments Choice of rate is a matter of judgment

FDM11 Capital investment apprasal 3 Decision-making criteria Policy for investment decisions must include choice of method and criteria May include use of 2 or more methods together Criteria will determine what decision is made –Financial recommendation depends on criteria not appraisal method NPV – set discount rate to be used –Higher discount rate leads to lower NPV IRR – hurdle rate to be met Payback – minimum payback period

FDM11 Capital investment apprasal 3 Managing the investment process Determine the funds available Identify possible project opportunities Evaluate the projects Make the decision –Decision may be made at different levels in organisation for different sizes of project Approve projects –Need process for authorising expenditure Monitor and control the investment –Including post-completion audit

FDM11 Capital investment apprasal 3 Evaluating a project Make estimates of cash flow Confirm criteria Carry out financial analysis Review analysis –Confirm quality of information used –Identify and consider assumptions –Make use of risk assessment techniques Consider non-financial issues