1. Chapter 6: An Economic Appraisal Technique: PBP and ARR 2016-06-271Kim, GT IE of Chosun University

2. The Purpose of An Economic Appraisal An economic appraisal is a vein to accomplish a corporate objective. In other words, it is commensurate with evaluating the corporate strategies so as to improve stockholders’ wealth by implementing a most desirable projects. The types of investment projects; i) service (cost) projects: those which are with regard to reducing costs. (ex. A power plant may need to decide one fuel resource to generate electricity between gas and oil.) ii) revenue projects: those which are concerned with increasing a firm’s revenue.(ex. A company may need to decide which one to produce to increase its profit or revenue between a HD and plain tv) All projects need cash outflows at the outset and generates cash inflows in the following times. 2016-06-272Kim, GT IE of Chosun University

3.  Depending on whether or not the interest concept is involved. - Appraisal techniques without interest involved. (1) payback period(PB) (2) accounting rate of return(ARR) - Appraisal techniques with interest involved. (1) net present value(NPV) (2) annual equivalent value(AE) (3) internal rate of return(IRR) Appraisal Techniques 2016-06-273Kim, GT IE of Chosun University

4.  Depending on the final value of the results which are provided by the appraisal techniques - appraisal techniques with an absolute value i) conventional & discounted PB ii) NPV iii) AE - appraisal techniques with a relative value i) ARR ii) IRR Appraisal Techniques 2016-06-274Kim, GT IE of Chosun University

5. Tech.%* Firm SizePERDebtDividendIndustryOwnership AvgSmallBigGNGHLYNMNMLH IRR75.613.092.873.413.36 2.853.363.432.683.192.943.342.85 NPV74.933.082.833.423.303.272.843.393.352.763.232.823.352.77 PB56.742.532.722.252.552.412.582.46 2.632.682.332.392.70 MARR56.942.482.132.952.782.872.272.632.842.062.602.292.702.12 SA51.542.311.582.562.352.412.102.562.422.172.352.242.372.18 DPB29.451.561.471.551.521.671.491.641.541.621.611.501.491.76 ROA26.591.471.341.571.311.551.501.411.371.521.491.451.401.52 ARR20.291.340.951.251.431.191.341.321.401.271.361.341.301.44 SA**13.660.950.851.220.840.860.781.101.040.820.950.920.950.86 APV10.780.850.830.720.970.690.870.800.910.780.920.790.99 PI11.870.830.750.730.810.740.810.830.900.760.810.98 The Utilization of the Appraisal Techniques PER: price-earning ratio, G: growth, NG: no-growth, H: hight, L: low, Y: yes, N: no, M: a manufacturing industry, NM: a non-manufacturing industry, IRR: internal rate of return, NPV: net present value, PB: payback period, MARR: minimum attractive of return, SA: sensitivity analysis, DPB: discounted payback period, ROA: real options approach, ARR: accounting rate of return, SA ** : simulation analysis, APV: adjusted present value, PI: profitability index 2016-06-275Kim, GT IE of Chosun University

6.  Principle - To be a period of time spent to fully recover the initial investment cost  Method - It is determined based on the cumulative amount of cash flows. A PB is found to be one which satisfies the equation above.  Decision Criteria - If A PB is less than the predetermined period of time, undertake the project and perform the following sophisticated evaluation techniques. Otherwise, reject it.  The Types of PB i) Traditional payback period(TPBP): no interest concept considered. ii) Discounted payback period (DPB): interest concept considered. Payback Period 2016-06-276Kim, GT IE of Chosun University

7. Traditional Payback Period N CF CCF 012345012345 -30,000 9,000 -30,000 -21,000 -12,000 -3,000 6,000 15,000 A TPBP is determined between 3 and 4 years. TPBP= 3.33 years (unit: 000 won) 2016-06-277Kim, GT IE of Chosun University

8. A Conventional Payback Period A TPBP based on the a real cash flow A TPBP based on a nominal cash flow nReal CFCCFNominal CFCCF 012345012345 -300,000 90,000 -300,000 -210,000 -12,000 -3,000 6,000 15,000 -300,000 9,900 10,890 11,979 13,177 14,495 -300,000 -20,100 -9,210 2,769 15,946 30,441 (unit: 000 won) 2016-06-278Kim, GT IE of Chosun University

9. A Conventional Payback Period Ex 6.1] Determine a TPBP Given] The initial investment costs of project A and B: 120 m won and 150 m won A project life of A and B are 3 and 7 years n A B CFCCFCFCCF 0123456701234567 -120,000 60,000 -120,000 -60,000 0 60,000 -150,000 50,000 -150,000 -100,000 -50,000 0 50,000 100,000 150,000 200,000 IRR23.4% 27% 2016-06-279Kim, GT IE of Chosun University

10.  Principle - TPBP + Interest Concept Employed  Decision Criteria - To be one which makes a cumulative cash flow zero - NPV=0  Equation Discounted Payback Period 2016-06-2710Kim, GT IE of Chosun University

11. Ex 6.2] Determine a discounted payback period for the project for an automatic machining center Given] Cash flows for the project, interest rate=15% DPBP 0 62,500 33,982 33,726 33,205 33,135 82,013 n Unit: ooo won 12345 2016-06-2711Kim, GT IE of Chosun University

12. Sol] determine a DPBP DPBP N012345 NCF-62,50033,98233,72633,20533,13582,013 CCF * -62,500-28,518-5,20838,41371,548153,562 Interest Factor (P/F,15%,0) =1 (P/F,15%,1) =0.870 (P/F,15%,2) =0.7561 (P/F,15%,3) =0.658 (P/F,15%,4) =0.572 (P/F,15%,5) =0.4971 Discounted CF-62,50029,56425,50021,84818,953 40,768 ** Cum DCF *** -62,500-32,936-7,43614,41233,36574,134 * : Cumulative Cash Flow without considering an interest rate ** : Discounted Cash Flow= NCF * Interest Factor *** : Cumulative Discounted Cash Flow 2016-06-2712Kim, GT IE of Chosun University

13. A Relationship Between PB and ROR i 0 P A 1 A 2 A 3 A 4 A N ………………………… where, P: present value, A: equal amount of a cash flow N: project life, i: interest rate 2016-06-2713Kim, GT IE of Chosun University

14. if a project life is infinite, i.e., “ ”, The equation above is called a capitalized equivalent (CE). - A relationship between a PB and IRR PBApprox. IRR 3년3년 33% 4년4년 25% 5년5년 20% 6년6년 17% 7년7년 14% 2016-06-2714Kim, GT IE of Chosun University A Relationship Between PB and ROR

15. Ex 6.3] A adequate Case for A Traditional Payback Period Given] A investment cost for installing a heating and air conditioning system in the class: May=3.375m won, Jun=1.125m won, a cost saving of electricity: Jun. to Aug. =450, 000 won, Apr. to May & Sep to Oct=225,000 won, Nov. to Mar=337,000 won Sol] Determine a traditional payback period 20092010 moCFCCFCFCCF 5 6 7 8 9 10 11 12 1 2 3 4 -3,375 -1,125 450 225 337.5 225 -3,375 -4,500 -4,050 -3,600 -3,375 -3,150 -2,812.5 -2,475 -2,137.5 -1,800 -1,462.5 -1,237 225 450 -1,012.5 -562.5 -112.5 337.5 PBP 15.25months When The Payback Period Technique Can Be Properly Used: It is better to use for a case in which the project life is measured in a month rather than a year. (unit: 000 won) 2016-06-2715Kim, GT IE of Chosun University

16. Ex 6.4] Measure Risk with a Payback Period Given] A investment cost for installing a heating and air conditioning system in the class: May=3.375m won, Jun=1.125m won, a cost saving of electricity: Jun. to Aug. =450, 000 won, Apr. to May & Sep to Oct=225,000 won, Nov. to Mar=337,000 won, Interest Rate =12% Sol] Determine a discounted payback period A Risk Measuring with A Payback Period (unit: 000 won) 20092010 moCFCCFCFCCF 5 6 7 8 9 10 11 12 1 2 3 4 -3,375 -1,125 450 225 337.5 225 -3,408.8 -4,579.1 -4,174.9 -3,766.6 -3,579.3 -3,390.1 -3,086.5 -2,780.0 -2,470.2 -2,157.4 -1,841.4 -1,634.8 225 450 225 337.5 -1,426.2 -990.5 -550.4 -106.0 118.1 344.3 685.2 투자회수기간 16.47 개월  Project Balance: PB 2016-06-2716Kim, GT IE of Chosun University

17. 2016-06-2717Kim, GT IE of Chosun University A Risk Measuring with A Payback Period

18. Ex 6.6] Determine an ARR with an average investment capital Given] I: 500 m won, life: 5 years, No salvage value at the end of year 5: 0, The relevant financial date Accounting Rate of Return n 12345 Rev 433,333450,000266,667200,000133,333 Expenses 200,000150,000100,000 BTCF 233,333300,000166,667100,00033,333 Dep 100,000 BTI 133,333200,00066,6670-66,667 Tax (25%) 33,33350,00016,6670-16,667 NI 100,000150,00050,0000-50,000 2016-06-2718Kim, GT IE of Chosun University

19. - Step 1: derive an after-tax average income - Step 2: determine an average investment capital - Step 3: Determine an ARR 2016-06-2719Kim, GT IE of Chosun University Accounting Rate of Return