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