1. Evaluating financial feasibility of long term Investment opportunities

2. What are 'Long-Term Investments'
A long-term investment is an account on the asset side of a company's balance sheet that represents the company's investments, including property plant and equipment, that it intends to hold for more than a year. The long-term investment account differs largely from the short-term investment account in that the short-term investments will most likely be sold, whereas the long-term investments may never be sold.
Winfield Academy of Business and Finance
5/1/2019

3. Capitalizing growth potential (Strategic options)
Organic growth
Inorganic growth
Main features
High risk
High capital investment
Winfield Academy of Business and Finance
5/1/2019

4. Evaluating strategic options Johnson's and Scholes 3 strategic test
Financial feasibility
Suitability (Organization resources and capability
Acceptability (Sustainability )
Winfield Academy of Business and Finance
5/1/2019

5. Evaluating financial feasibility of strategic options Investment Appraisal Methods
Discounted Cash Flow Methods
Net Present Value (NPV)
Internal Rate of Return (IRR)
Non-Discounted Cash Flow Methods
Payback Method

6. Discounted Cash Flow Methods
NPV - the sum of discounted future cash flows less the initial cost
IRR - the discount rate where NPV = 0

7. Compounding interest rate
FV= PV (1+R)N
FV=Future value
PV=Present value
R=Rate of return
N=Number of years

8. Example
If you invest 100,000 for 5 years at a rate of 7%, what would be the value of the investment after 5years.
If you invest 500,000 for 5 years at a rate of 9%, what would be the value of the investment after 5 years
If you invest 400,000 for 5 years at a rate of 10%, what would be the value of the investment after 5years. Interest will be compounded on a quarter basis.
If you need to have 500,000 value of investment in after 5 years at rate of 8%, how much will you invest today?
If you need to have $ 1 value of investment in after 5 years at rate of 8%, how much will you invest today?

9. Net Present Value (NPV)C1
(1 + r)1 + C2
(1 + r)2 + C3
(1 + r)3
- C0
Initial Cost
Discounted cash flows
C1, C2, C3 = the project cash flows,
r = discount rate (related to risk of the project)
C0 = initial cost

10. Investment Decisions
The board of directors of Magoo plc. is considering investing in a new machine that is expected to have a three year life and will cost £100,000. The machine is used to produce a good that is expected to have the following cash flows over the three years of the machine’s life - Year 1 = £30,000; Year 2 = £50,000; Year 3 = £40,000.
The firm expects to obtain a 12% return on a project of similar risk
Should it purchase the machine?

11. Fundamental Rule of Finance/Financial Economics
A capital investment decision is only worthwhile if it adds value. Thus, invest only in projects with a positive net present value

12. INTERNAL RATE OF RETURN (IRR)
Also based on Discounted Cash Flow, but calculates the discount rate that will give a Net Present Value of zero.
This also represents the return that the project is giving on the original investment, expressed in DCF terms.
The simplest way is to use trial and error - trying different rates until the correct rate is found. But this is laborious.
There is a formula, using linear interpolation.
Projects should be accepted if their IRR is greater than the cost of capital or hurdle rate.

13. IRR – Interpolation method
Where: L is the lowest discount rate
H is the higher discount rate
NL is the NPV of the lower rate
NH is the NPV of the higher rate

14. NPV and IRR
Gullane plc. are considering investing in a new machine that will cost £1 million. They estimate the machine will lead to an increase cash flow for the next three years of £500,000 in year 1, £600,000 in year 2, and £400,000 in year 3.
Given that Gullane plc. determine that the cost of capital is 10%, calculate the Net Present Value of the machine and recommend whether to ahead with the investment or not
Calculate the Internal Rate of Return of the machine

15. NPV is positive, therefore go ahead with investment
Example of NPV
Year PV 1
500,000/1.1 =
454,545.45 2
600,000/(1.1)2 =
495,867.77 3
400,000/(1.1)3 =
300,525.92
1,250,939.14
NPV = PV - Cost = 1,250, m = £250,939
NPV is positive, therefore go ahead with investment

16. Example of IRR - using r = 20%
Year PV 1
500,000/1.2 =
416,666.7 2
600,000/(1.2)2 = 3
400,000/(1.2)3 =
231,481.5
1,064,815
NPV = PV - Cost = 1,064, m = £64,815

17. Example of IRR - using r = 25%
Year PV 1
500,000/1.25 =
400,000 2
600,000/(1.25)2 =
384,000 3
400,000/(1.25)3 =
204,800
988,880
NPV = PV - Cost = 988, m = (£11,200)

18. IRR - cont.
64,815
76,015
IRR = 20 +
x ( )
= %
To check result, calculate NPV with r = % and ensure result has NPV = zero

19. Internal Rate of Return Decision Rules
If k > r reject. If the opportunity cost of capital (k) is greater than the internal rate of return (r) on a project then the investor is better served by not going ahead with the project and using the money to the best alternative use
If k < r accept. Here, the project under consideration produces the same or higher yield than investment elsewhere for a similar risk level

20. Non-discounted methods: Payback Period
Payback period - the length of time it takes to payback the initial investment
Payback Rule - choose the investment that pays back the initial investment the quickest

21. Example of Payback Period and ARR
Year
Cash Flow for Project Y (in HK$)
Cash Flow for Project Z (in HK$)
-200,000
-150,000 1
50,000
100,000 2 3
150,000
25,000

22. Example - cont. Project Y: 2.33 years (2 years 4 months)
Payback Period
Project Y: 2.33 years (2 years 4 months)
Project Z: 2 years
ARR
Project Y: [( )/200000]x100% = 50%
Project Z: [( )/150000]x100% = 16.67%
Payback Method choose project Z;
ARR method choose project Y

23. Problems with Non-Discounted Cash Flow Methods
Fails to take into account the time value of money and thus projects may lose value (money) despite apparently positive ARR.
Payback period ignores cash flows beyond payback and thus less profitable projects may be chosen.

24. Student Activity Year 0 Year 01 Year 02 Year 03 Investment 1,900,000
Ashanti plc., are considering an investment of 1.9 m to enter in to the north east region of Sri Lanka. The capital investment is expected to have equal lives of 3 years and the cash flows for each year is given below: Any capital expenditure project is evaluated at corporate WACC as a hurdle rate.
First year of the project is exempted from tax and 10% is applied after that.
Year 0
Year 01
Year 02
Year 03
Investment
1,900,000
Revenue
1,000,000
1,400,000
2,000,000
Operational cost
300,000
Ashanthi plc has 10 million equity and 5 million debt. It has 10% pa interest payment commitment in its debt and shareholders require 14 % return on their investment. The corporation tax rate is 28%.
You are required to evaluate the financial feasibility of the new expansion using NPV, IRR and the pay back period.