Capital Investment Appraisal

Capital Investment Appraisal

Aims… For you to be able to understand the concepts of Payback, ARR, IRR, DCF & NPV To be able to calculate Investment Appraisal methods.

What is an Investment? Any act which involves the sacrifice of an immediate and certain level of consumption in exchange for the expectation of an increase in future consumption. forgo the present consumption in order to increase resources in future

What is an Investment? An investment requires expenditure on something today that is expected to provide a benefit in the future the decision to make an investment is extremely important because it implies; the expectation that expenditure today will generate future cash gains in real terms that greatly exceed the funds spent today

Investment Appraisal A means of assessing whether an investment project is worthwhile or not Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc

Investment Appraisal Types of investment appraisal: Payback Period
Average Rate of Return (ARR) Net Present Value (discounted cash flow) What factors need to be considered before investing in equipment such as this? Source: Gergely Erno,

Investment Appraisal Why do companies invest?
Importance of remembering investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank! Buy equipment/machinery or build new plant to: Increase capacity (amount that can be produced) which means: Demand can be met and this generates sales revenue Increased efficiency and productivity

Investment Appraisal Investment therefore assumes that the investment will yield future income streams Investment appraisal is all about assessing these income streams against the cost of the investment Not a precise science! A fork lift may be an important item but what does it contribute to overall sales? How long and how much work would it have to do to repay its initial cost?

Looking at the figures…
A failing farmer wants to investigate the financial implications of possible farm diversification.

Farm Diversification – the 3 options
So what other factors should the farmer consider before deciding on which project to go with? Project A B C Years Goats Poultry Fish hatchery (20,000) (10,000) 1 10,000 200 2 3 5,000 16,000 4 18,000 Payback 2 years 3 years 3 mths 3 years 7 mths NPV * 7000 7522 4760 ARR 12.5% 15.5% 20% What are the 3 options for diversification? What do they think payback means? NPV? And ARR?

What other factors? State of the farming industry Price of land
Interest rates The economy – growing or shrinking? The farmers interests – no good doing something the family has no interest in! Competition in area Level of demand for each option!

Capital Budgeting Outcome is uncertain.
Large amounts of money involved. Investment involves long-term commitment. Decision may be difficult or impossible to reverse.

The Five Main Investment Appraisal Criteria Methods

Payback Method Payback method - length of time it takes to repay the cost of initial investment

Payback Method LBS Ltd uses the payback period as its sole investment appraisal method. LBS invests ¢ 30,000 to replace its computers and this investment returns ¢ 9,000 annually for the five years. From the information above evaluate the investment using the payback. Assume that ¢ 9,000 accrues evenly throughout the year.

Payback Method Solution Year Yearly cash flow cumulative net cash flow
¢ ¢ 0 (30,000) (30,000) 1 9, (21,000) 2 9, (12,000) 3 9, (3,000) 4 9, ,000 5 9, ,000 Therefore 3years = 27,000 then 3000/9000 x 12 = 4 Payback period = 3 years 4months

Expected annual net cash inflow
Payback Period Time period required to recover the cost of the investment from the annual cash inflow produced by the investment. Amount invested Expected annual net cash inflow

Payback Method The length of time taken to repay the initial capital cost Requires information on the revenue the investment generates E.g. A machine costs ¢600,000 It produces items that sell at ¢ 5 each and produces 60,000 units per year Payback period will be ?????

Payback Method 2 Years Computed as; 600,000 / 300,000 = 2

Example Casey Co. is considering an investment of ¢130,000 in new equipment. The new equipment is expected to last 10 years. It will have zero salvage value at the end of its useful life. The straight-line method of depreciation is used for accounting purposes. The expected annual revenues and costs of the new product that will be produced from the investment are: Sales ¢200,000 Cost of goods sold ¢145,000 Depreciation expense 13,000 Selling & Admin expense 22, ,000 Income before income tax ¢20,000 Income tax expense 7,000 Net Income ¢13,000

Computation of Annual Cash Inflow
Expected annual net cash inflow = Net income ¢13,000 Depreciation expense 13,000 ¢26,000

Cash Payback Period 130,000 / 26,000 = 5 years

**Operating Cashflow During 2009, RIT Corp. had sales of $798,456. Costs of goods sold, administrative and selling expenses, and depreciation expenses were $565,600, $98,555, and $89,561, respectively. In addition, the company had an interest expense of $223,544 and a tax rate of 35 percent. What is the operating cash flow for 2009? Ignore any tax loss carry-back or carry-forward provisions.

Operating Cashflow Solution
Sales 798,456 COGS 565,600 Admin & Selling Expenses 98,555 Depreciation 89,561 Interest Expense 223,544 Tax Rate 35% Operating Cashflow = EBIT + Depreciation - Income Taxes EBIT = Earnings Before Interest and Taxes EBIT = Revenue - Operating Expenses EBIT = Sales -COGS - Admin & Selling Expenses - Depreciation EBIT = 44,740 Tax 15,659 Operating Cashflow = ((44, , ,659)) 118,642

**Cashflow to stockholders & creditors
M & M Foods Financial Statements 2008 2009 Sales 6,831 7,866 COGS 4,760 5,236 Interest 331 380 Depreciation 221 289 Cash 450 468 Account Receivables 2,214 2,650 Current Liabilities 991 2,238 Inventory 2,564 2,651 Long-term debt 3,522 2,400 Net fixed assets 5,040 5,542 Common stock 2,365 3,641 Taxes 566 716 A. What is the cash flow to stockholders for 2009? B. What is the cash flow to creditors for 2009?

Solution Cashflow to stockholders = Cashflow from Assets - Cashflow to Creditors Cashflow from Assets = Operating cashflow - Net Capital Spending - change in net capital Cashflow to creditors = Interest - Net new borrowing Operating Cashflow = Sales -COGS - Depreciation + (Depreciation - Taxes) Net New Borrowing = Long term debt Long term debt Net Capital Spending = net fixed assets net fixed assets Depreciation Change in NWC = 2009(cash + A/R + inventory - Current Liabilities) Minus 2008 (cash + A/R + Inventory - Current Liabilities) Operating Cashflow = EBIT + Depreciation - Income Taxes

Solution cont’d Operating Cashflow = Sales-COGS- Depreciation + Depreciation -Taxes Operating Cashflow 1,914 Net Capital Spending = 2009 net fixed assets net fixed assets Depreciation Net Capital Spending 791 Change in NWC = 2009(cash + A/R + inventory - Current Liabilities) Minus 2008 (cash + A/R + Inventory - Current Liabilities) Change in NWC (706) Cashflow from Assets = Operating cashflow - Net Capital Spending - change in net capital Cashflow from assets 1,829 Net New Borrowing = Long term debt Long term debt Net new borrowing (1,122) Cashflow to creditors 1,502 Cashflow to stockholders 327

Payback Period – Uneven Cash Flows
Casey Co. wants to install a machine that costs ¢16,000 and has an 8-year useful life with zero salvage value. Annual net cash flows are:

Payback Period – Uneven Cash Flows
We recover the ¢16,000 purchase price between years 4 and 5, about 4.2 years for the payback period. 4.2

Using the Payback Period
Payback = 5 years Payback = 3 years Consider two projects, each with a 5-year life and each costing ¢6,000. Would you invest in Project One just because it has a shorter payback period?

Payback method Payback could occur during a year
Can take account of this by reducing the cash inflows from the investment to days, weeks or years.

What’s just over a 1/3 of a year?
Payback Method Payback formula = 600,000 255,000 = 2.35 years What’s just over a 1/3 of a year? = 4 months = 2 years and 5 months… Payback formula 2 years = 255, ,000 = 510,000 = 2 years & some months…. 600, ,000 = 90,000 still owing 255,000 = 21,250 12 months = 90,000 = month 21,250 = 2 years and 5 months… e.g. Cost of machine = ¢ 600,000 Annual income streams from investment = ¢ 255,000 per year Payback is some where between … Year 2 & year 3 it will pay back – but when? Income Year 1 255,000 Year 2 Year 3

Average Rate of Return A comparison of the profit generated by the investment with the cost of the investment Average annual return or annual profit ARR = Initial cost of investment

Average Rate of Return Average annual operating income from asset Average amount invested in asset Compare accounting rate of return to company’s required minimum rate of return for investments of similar risk. The minimum return is based on the company’s cost of capital.

Accounting Rate of Return
Average Investment = Original Investment + Residual Value 2 For Casey, average investment = (¢130,000 + ¢0)/ 2 = ¢65,000

Solution to Accounting Rate of Return Problem
Average annual operating income from asset Average amount invested in asset ¢13, / ¢65, = %

The decision rule is: A project is acceptable if its rate of return is greater than management’s minimum rate of return. The higher the rate of return for a given risk, the more attractive the investment.

An investment is expected to yield cash flows of ¢ 10,000 annually for the next 5 years. The initial cost of the investment is ¢ 20,000 Total profit therefore is: ¢ 30,000 (50,000-20,000) Annual profit = ¢ 30,000 / 5 = ¢ 6,000 ARR = 6,000/20,000 x 100 = 30% Is this a worthwhile return? Need to compare to interest rates as well alternatives.

ARR- do you need a formula?
Total revenue (over lifetime) – purchase price = total profit Total profit / life time of product = average profit Average profit / purchase price = ARR x 100 = ARR %

Investment Appraisal ¢ now ¢ in 5 years time Which is worth more?
To make a more informed decision, more sophisticated techniques need to be used. Importance of time-value of money

Discounted Cash Flows Considers both the estimated total cash inflows and the time value of money. Two methods 1) net present value 2) internal rate of return

Investment Appraisal Purchasing power would have been lost over a year due to inflation money could have been alternatively invested in say risk-free Government securities

Net Present Value NPV is today’s value of the difference between cash inflows and outflows projected at future dates, attributable to capital investments or long-term projects

Net Present Value Takes into account the fact that money's value change with time How much would you need to invest today to earn x amount in x years time? Value of money is affected by interest rates NPV helps to take these factors into consideration Shows you what your investment would have earned in an alternative investment regime

Net Present Value e.g. Project A costs ¢ 1,000,000
After 5 years the cash returns = ¢ 100,000 (10%) If you had invested the ¢ 1 million into a bank offering interest at 12% the returns would be greater - You might be better off re-considering your investment!

Net Present Value The principle:
How much would you have to invest now to earn ¢ 100 in 1 year’s time if the interest rate was 5%? The amount invested would need to be: ¢ 95 Allows comparison of an investment by valuing cash payments on the project and cash receipts expected to be earned over the lifetime of the investment at the same point in time, i.e the present.

Don’t need to know this formula!! PV = -----------------
Net Present Value Don’t need to know this formula!! Future Value PV = (1 + i)n Where i = interest rate n = number of years The Present Value of ¢ 10% in 1 year’s time is If you invested p today and the interest rate was 10% you would have ¢ 1 in a year’s time Process referred to as: ‘Discounting Cash Flow’

Net Present Value Cash flow x discount factor = present value
e.g. PV of ¢ 500 in 10 years time at a rate of interest of 4.25% = 500 x = ¢ ¢ is what you would have to invest today at a rate of interest of 4.25% to earn ¢ 500 in 10 years time PVs can be found through valuation tables (Always given to you in exams!)

Discounted Cash Flow An example:
A firm is deciding on investing in an energy efficiency system. Two possible systems are under investigation 1 yields quicker results in terms of energy savings than the other but the second may be more efficient later Which should the firm invest in?

Discounted Cash Flow – System A
Year Cash Flow (£) Discount Factor (4.75%) Present Value (£) (CF x DF) - (600,000) 1.00 -(600,000) 1 +75,000 71,599.04 2 +100,000 91,136.41 3 +150,000 130,505.61 4 +200,000 166,116.92 5 +210,000 166,513.39 6 113,544.75 Total 285,000 NPV =139,416 Watch this….

Discounted Cash Flow – System B
Year Cash Flow (£) Discount Factor (4.75%) Present Value (£) (CF x DF) - (600,000) 1.00 -(600,000) 1 +25,000 23,866.35 2 +75,000 68,352.31 3 +85,000 73,953.18 4 +100,000 83,058.46 5 +150,000 118,938.10 6 +450,000 340,634.30 Total 285,000 NPV =108,802.70 Watch this….

What would you prefer…a ¢ 50 today or ¢ 100 in 3 years time?
Discounted Cash Flow System A represents the better investment…. But why? System B yields the same cash return after 6 years but the NET returns of System A occur faster and are worth more to the firm than returns occurring in future years even though those returns are greater Absolutely vital to remember this for evaluation! What would you prefer…a ¢ 50 today or ¢ 100 in 3 years time?

Net Present Value Method
Find PV of future cash flows and compare with capital outlay Interest rate used = required minimum rate of return Proposal is acceptable when NPV is zero or positive. The higher the positive NPV, the more attractive the investment.

Net Present Value We will assume that Casey Co’s annual cash inflows of ¢26,000 are uniform over the asset’s useful life. The present value of the annual cash inflows can be computed by using the present value of an annuity of 1 for 10 periods. Assume the company requires a minimum return of 12%.

Present value of cash flows
Net Present Value Cash Flow When? Type of cash flow Present value factor Present value of cash flows (130,000) Now (¢130,000) NPV 26,000 Yrs 1-10 Annuity 5.650 146,900 ¢ 16,900 Analysis of the proposal: The proposed capital expenditure is acceptable at a required rate of return of 12% because the net present value is positive

Net Present Value When annual cash inflows are unequal, use present value of one tables.

Net Present Value Cash Flow When? Type of cash flow PV factor
(130,000) Now ($130,000) 36,000 1 Lump sum .893 32,148 32,000 2 “ .797 25,504 29,000 3 .712 20,648 27,000 4 .636 17,172 26,000 5 .567 14,742 24,000 6 .507 12,168 23,000 7 .452 10,396 22,000 8 .404 8,888 21,000 9 .361 7,581 20,000 10 .322 6,440 NPV $25,687 Net Present Value ,,

Internal Rate of Return
Interest yield of the potential investment The interest rate that will cause the present value of the proposed capital expenditure to equal the present value of the expected annual cash inflows.

Internal Rate of Return
STEP 1.Compute the internal rate of return factor using this formula: Capital Investment Annual Cash Inflows 130,000 / , = 5

Internal Rate of Return Method
STEP 2. Use the factor and the present value of an annuity of 1 table to find the internal rate of return. Locate the discount factor that is closest to 5.0 on the line for 10 periods.

Internal Rate of Return Decision Criteria
The decision rule is: Accept when internal rate of return is equal to or greater than the required rate of return Reject when internal rate of return is less than required rate

Internal Rate of Return – Uneven Cash Flows
If cash inflows are unequal, trial and error solution will result if present value tables are used. Use business calculators and electronic spreadsheets

Profitability Index (PI)
Measures the benefit per unit cost, based on the time value of money A profitability index of 1.1 implies that for every ¢1 of investment, we create an additional ¢0.10 in value This measure can be very useful in situations where we have limited capital

In other words, PI shows the relative profitability of any project, or the present value per cedi of initial cost PV of future cash flows Initial Cost Compute the PI for a project with initial cost of ¢ 130,000 with an NPV of ¢ 16,900

Answer Initial cost = 130,000 NPV = 16,900 PV of future cash flows = 146,900 146,900 130,000 = 1.13

**Net Present Value Jasper Metals is considering installing a new molding machine which is expected to produce operating cash flows of $78,000 a year for 7 years. At the beginning of the project, inventory will decrease by $19,000, accounts receivables will increase by $24,000, and accounts payable will increase by $18,000. All net working capital will be recovered at the end of the project. The initial cost of the molding machine is $279,000. The equipment will be depreciated straight-line to a zero book value over the life of the project. The equipment will be salvaged at the end of the project creating a $52,000 aftertax cash flow. At the end of the project, net working capital will return to its normal level. What is the Net Present Value of this project given a required return of 14.5 percent? (B) Calculate the project Profitability Index

Solution Cashflow for initial year CF0 Initial cost (279,000)
Inventory decrease 19,000 Account Receivable increase (24,000) Account payable increase 18,000 = (-279, , , ,000) (266,000)

Solution cont’d Cashflow for year 7 CO7 Yearly cashflow 78,000
Salvaged Equipment after tax cashflow 52,000 Inventory decrease (initial year) (19,000) Account Receivable increase (initial year) 24,000 Account payable increase (initial year) (18,000) = (78, , , , ,000) 117,000

Solution cont’d NPV Computation Rate of return r = 14.50% ( r = 0.145) Period/Number of years = n = 7 NPV = CF0 + yearly cashflow * [1 - ((1/(1 + r)^n-1)/r) ] +[ CO7/(1 + r)^n] NPV = (-279, ,000 * [1-1/( )^7-1/0.145] + 117,000/( )^7 78,555.24 (B) Profitability Index, PI, is calculated as PV of future cash flows Initial year cashflow PV of future cash flows 78,555.24 Initial year cashflow 266,000 PI 0.2953

Solution cont’d ( C ) An investment project cost $23,500 and has annual cash flows of $6,800 for 6 years. If the discount rate is 20 percent, what is the discounted payback period? PV = Annual cashflow * [1-((1/(1+r)^n))/r)] Annual cashflow 6,800 Discount rate, r 20% 0.2 Period, n 6 PV = 22,613.47

Advantages and Disadvantages of Profitability Index
Closely related to NPV, generally leading to identical decisions Easy to understand and communicate May be useful when available investment funds are limited Disadvantages May lead to incorrect decisions in comparisons of mutually exclusive investments

Comparing Methods

IRR and Mutually Exclusive Projects
If you choose one, you can’t choose the other Example: You could have chosen to attend graduate school at either KNUST or GTUC (Coventry), but not both Intuitively you would use the following decision rules: NPV – choose the project with the higher NPV IRR – choose the project with the higher IRR

Investment Appraisal Key considerations for firms in considering use:
Ease of use/degree of simplicity required Degree of accuracy required Extent to which future cash flows can be measured accurately Extent to which future interest rate movements can be factored in and predicted Necessity of factoring in effects of inflation Absolutely vital to also remember this for evaluation!

**More ratio problems Uptown Men's Wear has accounts payable of $4,428, inventory of $15,900, cash of $2,526 fixed assets of $16,800, accounts receivable of $7,814, and long-term debt of $8,400. What is the value of the net working capital to total assets ratio?

Solution Cash 2,526 AR 7,814 Inventory 15,900 Fixed assets 16,800 AP
4,428 Long Term Debt 8,400 Net working capital to Total assets ratio = Net Working Capital Total Assets Net working capital = Current assets - Current liabilities Cash + AR + Inventory - Accounts payable 21,812 Total Assets = Cash + AR + Inventory + Fixed Assets 43,040 Net working capital to Total assets ratio = 0.51

**Some more ratio issues
The Flower Shoppe has accounts receivable of $7,930, inventory of $7,044, sales of $548,226, and cost of goods sold of $412,899. How many days does it take the firm to both sell its inventory and collect the payment on the sale assuming that all sales are on credit? Sales 548,226 COGS 412,899 AR 7,930 Inventory 7,044 Days of the year 365 Days in inventory = 365 days Inventory Turnover ratio Days in inventory = 6.227 Days' Sales in receivables or Average Collection Period 365 Days Receivables Turnover ratio

Receivables Turnover ratio
Solution cont’d Receivables Turnover ratio Sales Accounts Receivable Days' Sales in receivables or Average Collection Period 5.280 Total days in Inventory and Receivables 11.507

**Some even more ratios
A firm has a debt-equity ratio of 67 percent, a total asset turnover of 1.36, and a profit margin of 9.4 percent. The total equity is $640,115. What is the amount of the net income? Debt - equity ratio 67% 0.67 Total assets turnover 1.36 Profit Margin 9.40% 0.049 Total Equity 640,511

Solution cont’d DuPont formula on ROE
ROE = (Profit margin)*(Asset turnover)*(Equity multiplier) Net Income * Sales Sales * Assets Assets Equity DuPont model tells that ROE is affected by three things: Operating efficiency, which is measured by net profit margin; Asset use efficiency, which is measured by total asset turnover; Financial leverage, which is measured by the equity multiplier; If ROE is unsatisfactory, the DuPont analysis helps locate the part of the business that is underperforming.

Solution cont’d Equity Multiplier = (1 + Debt to Equity Ratio)
Debt/Equity = 0.67 Debt = Assets - Equity Assets - Equity = Equity 0.67 Assets - Equity = 0.67 * Equity Assets = (0.67 * Equity) + Equity Assets = 0.67Equity + Equity Assets = Equity ( ) Return on equity = Profit Margin * Total Assets Turnover * (1 + Debt to Equity Ratio) (0.094 * 1.36 * ( ) Return on equity = Net Income Total Equity Net Income = Return on Equity * Total Equity 71,282

**Some more ratio issues
Use the below statements to answer question A to E TEW COMPANY Balance Sheet As of December 31, 2007 Assets Cash 70,000 Accounts Receivable 100,000 Inventory 85,000 PPE, net 455,000 Total Assets 710,000 Liabilities and Stockholders' Equity Accounts payable 95,000 Accrued expenses 116,000 Long Term Debt 195,000 Common Stock 168,000 Paid-in capital 38,000 Retained Earnings 98,000 Total Liabilities and SE

TEW COMPANY Income Statement For the Year Ended December 31, 2007 Sales (all on credit) 800,000 COGS 500,000 Gross Profit 300,000 Sales and Admin Expenses 40,000 Fixed Lease Expense 20,000 Depreciation 80,000 Operating Profit 160,000 Interest Expense Profit before Taxes 120,000 Taxes 35% 42,000 Net Income 78,000

Receivable Turnover ratio
(A). Refer to the figure above. The firm's return on equity is ROE = Net Income Shareholders' Equity 0.26 B). Refer to the figure above. The firm's average collection period is Average Collection Period= 365 Receivable Turnover ratio Sales on Account Accounts Receivable 8 45.625 days

Current assets - Inventory
(C). Refer to the figure above. Tew's quick ratio is Quick Ratio = Current assets - Inventory Current Liabilities 170,000 0.806 211,000 (D). Refer to the figure above. The firm's debt to asset ratio is Debt to Assets ratio = Total Debt Total Assets 406,000 710,000 0.57

Fixed charge coverage =
(E). Refer to the figure above. Fixed Charge coverage for Tew Company is (E). Refer to the figure above. Fixed Charge coverage for Tew Company is Fixed charge coverage = Earnings before interest and taxes + fixed charge Fixed charges + Interest 160,000 60,000 2.67 Interpretation: EBIT, Taxes, and Interest Expense are taken from the company's income statement. Lease Payments are taken from the balance sheet and are usually shown as a footnote on the balance sheet. The result of the fixed charge coverage ratio is the number of times the company can cover its fixed charges per year. The higher the number, the better the debt position of the firm, similar to the times interest earned ratio.

Capital Investment Appraisal

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