Presentation is loading. Please wait.

Presentation is loading. Please wait.

Investment Appraisal describe the various techniques and methods for assessing and appraising investment projects. use and critically appraise the methods,

Similar presentations


Presentation on theme: "Investment Appraisal describe the various techniques and methods for assessing and appraising investment projects. use and critically appraise the methods,"— Presentation transcript:

1 Investment Appraisal describe the various techniques and methods for assessing and appraising investment projects. use and critically appraise the methods, in order to control capital expenditure projects examine the alternative ways of calculating an appropriate discount rate in determining the present value of money

2 Need to Control Capital Assets
Organisations are usually committed to long-term assets for an extended time, creating the potential for Excess capacity that creates excess costs Scarce capacity that creates lost opportunities Capital Asset Expenditure (Capex) The amount of money committed to the acquisition of capital assets is usually quite large The long-term nature of capital assets creates risk

3 Capital Budgeting Five approaches are discussed here:
Capital budgeting is the collection of tools that planners use to evaluate the desirability of acquiring long-term assets Five approaches are discussed here: Accounting rate of return Payback Net Present Value Internal Rate of Return Profitability Index

4 Payback Criterion The payback period is the number of periods needed to recover a project’s initial investment Many people consider the payback period to be a measure of the project’s risk The organization has unrecovered investment during the payback period The longer the payback period, the higher the risk Organisations compare a project’s payback period with a target that reflects the organization’s acceptable level of risk

5 Problems with Payback The payback criterion has two problems:
It ignores the time value of money It ignores the cash outflows that occur after the initial investment and the cash inflows that occur after the payback period Some surveys show that the payback calculation is the most used approach by organisations for capital budgeting This popularity may reflect other considerations, such as bonuses that reward managers based on current profits, that create a preoccupation with short-run performance

6 Accounting Rate of Return
Analysts compute the accounting rate of return by dividing the profit by the average level of investment If the accounting rate of return exceeds the target rate of return, then the project is acceptable BUT By averaging, it does not consider the timing of cash flows This method is an improvement over the payback method in that it considers cash flows in all periods

7 Time Value of Money Time value of money (TVM) is a central concept in capital budgeting Because money can earn a return: Its value depends on when it is received Using money has a cost The lost opportunity to invest the money in another investment alternative In making investment decisions, the problem is that investment cash is paid out now, but the cash return is received in the future

8 Basic Principles of DCFs
Time Value of Money Single most important concept: £100 today is worth more than £100 in a year’s time If interest is 12% pa, then: Year 1: 100 x (1 + 12%) = 112 Year 2: 100 x (1+12%) x (1+12%) =

9 Future Value The future value (FV) is the amount that today’s investment will be after earning a stated periodic rate of return for a stated number of periods Because investment opportunities usually extend over multiple periods, we need to compute future value over several periods

10 Present Value Analysts call a future cash flow’s value at time zero its present value (PV) The process of computing present value is called discounting FV = PV x (1 + r)n PV = FV/(1 + r)n

11 FV with Multiple Periods
An initial amount of £1.00 accumulates to £ over five years if the annual rate of return is 5%: Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 1.000 1.050 1.102 $1.157 $1.215 $1.276 This calculation assumes the following: Interest earned stays invested until the end of year 5 The rate of return is constant

12 Choosing a Common Date An investment’s cash flows must be converted to their equivalent value at some common date in order to make meaningful comparisons between the project’s cash inflows and outflows The conventional choice is the point when the investment is undertaken Analysts call this time zero, or period zero Therefore, conventional capital budgeting analysis converts all future cash flows to their equivalent value at time zero

13 Decay of a Present Value
A fixed amount of cash to be received at some future time becomes less valuable as: Interest rates increase The time period before receipt of the cash increases One consequence of this decay is that large benefits expected far in the future will have relatively little current value, especially when interest rates exceed 10% Arbitrarily high interest rates will result in projects (especially long-term ones) being inappropriately turned down

14 Cost of Capital The cost of capital is the interest rate used for discounting future cash flows. Also known as the risk-adjusted discount rate The cost of capital is the return the organisation must earn on its investment to meet its investors’ return requirements The organisation’s cost of capital reflects: The amount and cost of debt and equity in its financial structure The financial market’s perception of the financial risk of the organization’s activities

15 Discount Rates - Calculations
In-house hurdle rate of acquirer Just given to you, based on not-always-logical assumptions; often the most practicable Dividend growth model Assumes that the share price of a listed firm is equal to the discounted value of dividends – butt ignores different levels of risk in alternative investment opportunities Borrowing rate The rate at which you obtain new funds (LIBOR plus some bps) – but it ignores the higher rate required by equity holders WACC (Weighted Average Cost of Capital)

16 Weighted Average Cost of Capital (WACC)
WACC = (Ke x MVe + Kd x MVd)/Total MV Ke = cost of equity, expressed as a % Kd = cost of debt, expressed as % MVe = market value of the equity MVd = market value of the debt Total MV = MVe + MVd

17 Capital Asset Pricing Model (CAPM)
CAPM forms the most often used basis for calculation of the discount rate It derives a value for the cost of equity which can then be fed into WACC calculation WACC (Weighted Average Cost of Capital): follows the intuition as it takes the average of the cost of debt and the cost of equity, weighted by their relative proportions

18 Cost of Debt To derive the WACC we now need to calculate the cost of debt: The simplest method is to take the risk free rate (from CAPM) and add a premium to reflect the cost of incremental borrowings for the investor. The Finance Director should have this info, alternatively, investment banks provide the estimate The cost of debt should, in theory, take into account any change of the firm’s credit rating due to the acquisition Pure theorists argues that ONLY marginal cost of debt should be used – higher than investor’s current borrowing rates

19 Terminal Value It is the value of the cash flows that arise after the planning period chosen for the detailed financial projections Terminal value may easily be much higher than the value of cash flows in the planning period Terminal value is based on the financial projections for the final year of the planning period

20 Terminal Value - risks The company is not yet fully taxed (losses brought forward, but they eventually will expire) The competitors did not catch up yet, so the company enjoys abnormally high market share Capex and R&D are still high, suggesting an increasing market share in the final year which will not occur in the long term

21 Net Present Value (1 of 2) The net present value (NPV) is the sum of the present values of a project’s cash flows It incorporates the time value of money The steps used to compute an investment’s net present value are as follows: Step 1: Choose the appropriate period length to evaluate the investment proposal The most common period used in practice is one year

22 Net Present Value (2 of 2) Step 2: Identify the organization’s cost of capital, and convert it to an appropriate rate of return. Step 3: Identify the incremental cash flow in each period of the project’s life Step 4: Compute the present value of each period’s cash flow using the organization’s cost of capital for the discount rate Step 5: Sum the present values of all the periodic cash inflows and outflows to determine net present value Step 6: If the project’s net present value is positive, the project is acceptable from an economic perspective

23 Internal Rate of Return (1 of 2)
The internal rate of return (IRR) is the actual rate of return expected from an investment The IRR is the discount rate that makes the investment’s net present value equal to zero If an investment’s NPV is positive, then its IRR exceeds its cost of capital If an investment’s NPV is negative, then it’s IRR is less than its cost of capital

24 Internal Rate of Return (2 of 2)
IRR has some disadvantages: It assumes that a project’s intermediate cash flows can be reinvested at the project’s IRR Frequently an invalid assumption It can create ambiguous results, particularly: When evaluating competing projects in situations where capital shortages prevent the organization from investing in all positive NPV projects When projects require significant outflows at different times during their lives Moreover, because a project’s NPV summarizes all its financial elements, using the IRR criterion is unnecessary when preparing capital budgets

25 Discounted Cash Flows (NPV & IRR)
Discounted Cash Flows (DCF) are generally accepted as being the primary valuation tool They should be used, if possible, alongside other valuation techniques (stock market multiples or net asset values) Use DCF ONLY when a sensible set of cash flow projections is available DCF contains a large number of assumptions: present them clearly

26 Profitability Index The profitability index is a variation of the net present value method It is used to make comparisons of mutually exclusive projects with different sizes and is computed by dividing the present value of the cash inflows by the present value of the cash outflows A profitability index of 1 or greater is required for the project to be acceptable

27 Uncertainty in Cash Flows
High – Low estimates Expected values – probabilities Wait and see – test market – prototype Sensitivity analysis at what level of the various data does the project become unviable (% change) What-if analysis – e.g. what if my sales are 90% of the plan.

28 Strategic Considerations/non-financial considerations
Long-term assets usually provide the following strategic hard-to-cost benefits: They allow an organization to make goods or deliver a service that competitors cannot They support improving product quality by reducing the potential to make mistakes They help shorten the production cycle time

29 Post-Implementation Audits
PIAs can provide an important discipline to capital budgeting When estimates are used to support proposals, recognising the behavioural implications is important This behaviour is mitigated if people understand that, once equipment is acquired, the company will compare results with the claims made in support of the equipment’s acquisition

30 Investment Appraisal Conclusion
Long term decision making Linked to strategy Similar to short term (it’s about revenues and costs) Different to short term (uncertainty of outcomes) Basic rules - quickest payback and most payback


Download ppt "Investment Appraisal describe the various techniques and methods for assessing and appraising investment projects. use and critically appraise the methods,"

Similar presentations


Ads by Google