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© 2005, Monash University, Australia CSE5806 Telecommunications Management Lecturer: Dr Carlo Kopp, PEng Lectures 15-16 Investment Decision Techniques Many projects compete for scarce capital & operational budgets. Which project should be chosen to go ahead, and why? (The one that gives the greatest return for the resources allocated)

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© 2005, Monash University, Australia Reference Sources NOTE: These sources are indicative - there are many other good texts available in libraries. They are referenced here as this presentation draws on them extensively Introductory Accounting and Finance Altehea Bell editor (1990) Publisher: Thomas Nelson Australia Monash University library: 657 B433.I Cost Accounting – a Managerial Emphasis Sixth Edition Horngren and Foster Publisher: Prentice Hall Monash Library: H657.4 H816C6 Engineering Economics – Analysis for Evaluation of Alternatives Kleinfeld, Ira (1993) Publisher: Van Nostrand Reinhold Monash University library: 658.15 K64E

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© 2005, Monash University, Australia Investment Decisions Management of existing assets Appraisal of future assets; Capital budgeting Balancing and sharing the use of capital monies among several/many competing demands Investment appraisal Considering which is the best way to invest our capital

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© 2005, Monash University, Australia Areas of capital budgeting: Forecasting Project Cash Flows Allowing For Uncertainty Cost Of Capital (Time-preference Rate) Arithmetic: Formulae & Tables Decision-making: Screening & Ranking May Be Mutually Exclusive Capital rationing

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© 2005, Monash University, Australia Discounted Cash Flow Analysis (DCF) DCF is a relatively new technique (US: late 50s, Europe 60s) Usually used for long-range decisions Considers time-value of money, Time value of money is based on the fact that future money is equated to todays money invested in some interest bearing scheme. Ie $100 invested today is worth, say, $110 magically acquired in two years time. Conversely $110 needed to pay for something in two years time equates to $100 today. Two main methods: internal rate of return (IRR) AND nett present value (NPV) Both methods require a year-by-year cash flow be developed ie projected costs and income flows - year-by-year Note that: depreciation/book value ignored it is covered by the initial purchase outgoing cash flow, and estimated disposal value giving an incoming cash flow at end of period depreciation is not a cash flow itself, but an accrual or allocation of funds interest payments not included (capital source is not part of the project.) Tables and tools are available for calculations of compound interest / discounting

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© 2005, Monash University, Australia Compound Interest and Discounts This calculator shows the factors for compounded interest (value increasing) and compounded discounting (value decreasing) for one unit (say, $1.00) over several years, at an annual rate of 10% See Tables 1 and 2 in handouts, and Compound Interest and Discounts.xls tool

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© 2005, Monash University, Australia DCF Example (1) A piece of land is bought for $4,500 (buying expenses of $218, interest rate of 10%), kept for 3 years (annual costs $50) and sold for $10,500 at the beginning of the 4th year (selling expenses are $500, therefore nett sales value is $10,000) Cash Flow Table DCF involves treating the later-year cash flows as though their value has declined by a certain proportion. (r%) That is, future money is considered to be worth less than present money The figures for future years must be discounted according to Table 2 factors Year01234 Raw Cash Flow -$4,718-$50 +$10,000

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© 2005, Monash University, Australia Nett Present Value (NPV) Discount each of the future cash flows by the cost of capital (k=10% per annum) and add them up. Subtract the capital outlay to get the NPV. If the NPV is > 0, the project can be considered as profitable if NPV = 0, the project is marginal if NPV is less than zero, the project is considered not worthwhile. NOTE: Increasing the discount rate drives the NPV down Present values of each years cash flows in the land purchase and sale are: The discounted values are calculated using the formula: discount (n,k) = 1/(1+k)**n Where n = number of years and k = discount rate +$7513.15-$37.57-$41.32-$45.45-$4,718.00 Value in current year terms (using k=10%) +$10,000.00-$50.00 -$4,718.00Cash flow 4 (Beginning of year ) 3210Year

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© 2005, Monash University, Australia NPV (2) Year01234 (beginning) Cash flow-$4,718.00-$50.00 +$10,000.0 0 Value in current year terms (using k=10%) -$4,718.00-$45.45-$41.32-$37.57+$7,513.15 Nett present value at each year 0-4718.00 -45.45 =-$4763.45 -4763.45- 41.32 =-$4804.77 -4804.77 -37.57 = -$4842.34 -4842.34 +7513.15 =+$2,670.8 1 The nett present value (in this years money) is:

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© 2005, Monash University, Australia Relationship: NPV and Discount Rate The relationship between the NPV and the discount rate k can be seen below As the discount rate increases, the NPV value is reduced. Discount Rate or Cost of Capital % 8%12%16%20% $ NPV NPV Profile

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© 2005, Monash University, Australia Internal Rate of Return (IRR) Also known as Time-adjusted Rate of /return If: C is the initial capital outlay Ai is the cash flow in year i then the IRR is r in the following formula: Another way to describe IRR is The interest rate that would make NPV = Zero, thus it is the maximum rate that could be paid to obtain capital for this project.

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© 2005, Monash University, Australia Relationship NPV and IRR The relationship between the NPV and the IRR can be seen below The IRR can also be used to estimate the maximum rate of interest to pay for funds. Discount Rate or Cost of Capital % 8%12%16%20% $ NPV NPV Profile IRR

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© 2005, Monash University, Australia Another Example Exhibit 19.2 in Horngren and Foster - "Cost Accounting - a Managerial Emphasis See spreadsheet Exhibit 19_2.xls for details

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© 2005, Monash University, Australia NPV or IRR? Which is best? Basically, both based on the same issues, and can be calculated for fixed or variable rates of discount or interest NPV has advantages: results are expressed in terms of money ($),not ratios (%). Money terms are more easily understood by people. IRR has advantages: results are expressed in terms of percentages that immediately identify the maximum rate of interest that could be paid for a loan to undertake the project. And disadvantages IRR is not so meaningful when the interest rate is expected to vary over the period - an average IRR can be calculated,but its relevance is questionable - whereas NPV is still expressed in terms of $$$

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© 2005, Monash University, Australia Choosing between Competing Projects Consider a simple example (assume k is 10%) Summary of the table: Project A returns more value for the initial outlay (IRR=20%) Project B produces a greater nett return of money ($1091) Which is the more financially rewarding project? Should we: choose the highest NPV? choose the highest IRR? Year 0Year 1IRRNPV Project A-$10,000+$12,00020%$909 Project B-$15,000+$17,70018%$1,091

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© 2005, Monash University, Australia Why the conflict in signals? We need to look at the "differential cash flow" (aka incremental cash flow) This evaluates the additional value (if any) of investment B over investment A ( Differential or Incremental Cash Flow) Subtract cash flows for A from cash flows for B,then calculate the IRR and NPV based on the differential or incremental cash flows if IRR inc > k choose the larger project If NPV inc > 0 choose the larger project Year 0Year 1IRRNPV Project A-$10,000+$12,00020%$909 Project B-$15,000+$17,70018%$1,091 B - A-$5,000+$5,70014% inc $182 inc IRR inc and NPV inc both indicate Project B Which do we choose?

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© 2005, Monash University, Australia Conflict in Signals (2) For ranking mutually exclusive projects, do not rank on IRR. Instead choose the highest NPV. (Only the incremental or differential IRR sends valid signals.) Need also to consider capital rationing. Consider what happens to the NPV profiles of both projects as k increases Mutually exclusive decisions are where a decision to go one way automatically prevents consideration of the other

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© 2005, Monash University, Australia Conflict in Signals (3) You can also consider the differential IRR as a breakpoint From previous slides, we can see that the differential IRR is 14% (about two slides back), and the NPVs are equal at $526 when k=14% (previous slide) NPVs always cross at the differential IRR

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© 2005, Monash University, Australia Cash Flow Elements in DCF Book value of: existing assets to be used for in project - ignore existing assets no longer needed - ignore or sell if significant Residual value of assets at the end of the project - sell; include estimated value (maybe?) Changes in working capital - include only if using accrual basis Interest expenses on loans - ignore, or treat as interest Taxation - include in each period Inflation - ignore, or include on consistent basis Future depreciation - NO!

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© 2005, Monash University, Australia Depreciation & DCF Arguments: Depreciation is not a real cash flow, so ignore it. but it affects tax, and therefore changes the real cash flow Options: ignore tax totally, and use a pre-tax discount rate include all tax effects, including the tax deductions associated with depreciation

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© 2005, Monash University, Australia Payback Period (PP) An old approach, largely superseded today by DCF approaches. Measures the time until the initial investment is recovered by profits. For screening projects: PP < target (e.g. 4 years) For ranking projects: choose lowest PP. Problems with the PP method 1. PP ignores the time value of money eg 0 1 2 3 4PPIRR Project A-300 50100150400 330.9% Project B-300150100 50400 336.2% PP cannot distinguish between Projects A and B in 1.above. 2. PP ignores cash flows after the payback has been reached eg 012345PP IRR. Project A-503020105527.83% Project B-5010202050100386.89% PP ranks Project A better than Project B in 2. above

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© 2005, Monash University, Australia PP Problems Projects with long incubation times (eg lengthy construction times) are unlikely to be favourably considered, despite having massive advantages after the Payback Period ends An arbitrary cutoff of project benefits occurs when comparing projects. This can lead to unscrupulous project proposers deliberately distorting the picture by inflating close in profits and ignoring profits beyond the PP Summary: The main problem with PP is that the following two concepts are ignored: time-value of money within the payback period, and operating profit beyond the payback period Problems expressed in DCF terms: k = 0 before the PP AND k = infinity after the PP

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© 2005, Monash University, Australia Common Arguments for PP Method Common arguments for PP methods are: good in times of uncertainty (because it is better to get your money back ASAP) good for capital rationing (because it recycles capital more quickly) PP is easier to calculate than DCF methods at any time, and particularly in times of change None of these arguments are really valid. PP still persists for reasons of tradition more than science. Decisions should be based on considering best information available, not on short term difficulty of working out the figures

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© 2005, Monash University, Australia Example of Project Ranking You are considering two types of communications controller for a project: Supplier A: Large switch with plenty of shelf-space. Would need extra shelves in 3 years. Approx. $500/yr of extra cards needed. Supplier B: Smaller initial unit, and stackable modules approx. $2,000/yr. The purchase schedule would be: 0 1 2 3 4 5 Supplier A$10,000 $ 500 $ 500 $ 2,000 $ 500 $ 500 Supplier B $ 6,500 $ 2,000 $ 2,000 $ 2,000 $ 2,000 $ 2,000 The maintenance costs each year are 10% of the purchase cost of the equipment in operation at that start of that year. Thus the year 5 maintenance for A is $1,350 and B is $1,450. 1. Assuming the company's cost-of-capital is 8%, which supplier's equipment has the lower discounted purchase and maintenance cost? 2. Your new finance director has just announced that investment funds are tight, and a discount rate of 20% is to be used for all project ranking decisions. Does this change things? 3. What would you do in this situation?

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© 2005, Monash University, Australia Project Ranking Example (2) Years>>> 0 1 2 3 4 5 Equipment A10,0005005002,000500500 Maintenance A-10001050110013001350 Total A10,0001,5001,5503,1001,8001,850 Equipment B6,5002,0002,0002,0002,0002,000 Maintenance B-6508501,0501,2501,450 Total B6,5002,6502,8503,0503,2503,450 Rate >>>8% 15% 20% NPV for Supplier A: $17,761$16,464$ 15,732 NPV for Supplier B: $18,555$16,538$ 15,406 Answers: Question 1: Lower NPV at 8% rate is Supplier A by $794 over 5 years Question 2. Lower NPV at 20% rate is Supplier B by $326 over 5 years – thus rate is significant Question 3: Results are very close at 20% and five years. You should discuss anticipated future rates with the finance director. If these are likely to increase significantly, then propose B because the increasing rate favours it over A. However, if likely to decrease or remain stable then propose A.

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© 2005, Monash University, Australia Lease or Buy? Leasing of equipment is a source of finance a finance organisation buys the equipment and leases it in return for regular payments over the entire lease period. Two main variations: finance leases (common property lease where ownership passes to the lessee) and operating leases (ownership does not pass to lessee at end of lease). Why lease? Form of finance (is it cheaper than alternatives?) Protection against obsolescence(?) only if can the lease be cancelled or replaced part way through Tax deductions for entire lease payments (but note that depreciation of equipment and the interest on a normal loan are deductible)

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© 2005, Monash University, Australia Leasing (2) Matters to question: Who handles the residual value at end of a lease, and how is it handled?. Is maintenance included in lease payments? Consumables generally not included eg paper, electricity etc But is a replacement laser drum a wear and tear maintenance item or a consumable - (and many other short-life components) Fire, theft, accidental damage insurance? Deliberate damage usually addressed separately How do you handle obsolescence of equipment during lease period? Who is funding the lease - and their financial stability? They have ownership, and if liquidated you may suddenly lose the use of the equipment Problem - as you do not own the leased equipment, you can neither sell nor substantially modify it without permission. In fact, can you modify it at all? Generally must return it in original condition, apart from fair wear and tear aspects DCF of lease will typically use an "implicit interest rate".

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© 2005, Monash University, Australia Telecommunications Investment Evaluation This material is loosely based information from Telstra about its investment decision-making methods in the 1990s. Distributed hierarchical approval system for projects from $2M to $50M ie applicable to middle range projects Smaller Projects had a simpler system Larger Projects (over $50M) needed Board approval. Basis was that Projects must: Conform to company strategy Be financially sound Meet investment evaluation criteria

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© 2005, Monash University, Australia Capital Expenditure Effectiveness & Efficiency Investment Decisions Strategic Planning Planning & Programming Implementation Monitoring Re-alignment of Objectives

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© 2005, Monash University, Australia Investment Evaluation DCF is used extensively Discount rate based on weighted effective cost of capital. Related to: cost of borrowing; expected return to shareholders Investment period based on: asset life and foreseeable cash flows NPV is calculated on both "hard" and "soft" cash flows High discount rates to allow for "capital rationing" is no longer used, as it tended towards short-term projects. Project selection weighted towards strategic directions

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© 2005, Monash University, Australia Investment Programming Increasing Risk New Revenue Opportunities Modernisation Productivity Service Quality Growth in Established Products Support Infrastructure Eg Replacing existing exchanges & lines Eg Buildings Vehicles Computers Eg Adding extra exchanges & lines Eg Rollout of new services mobiles phones, cable TV

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© 2005, Monash University, Australia Project Criteria Initial selection of projects biased toward: customer service market priorities/market share retention competitive edge Ongoing review criteria: Projects deviating by more than 10% from approved budget need re- approval. Projects lagging behind their planned progress by more than a set figure need re-approval

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© 2005, Monash University, Australia Telstra Gating Process Telstra has a set of six gates to evaluate and review medium size projects: during planning during development and testing, and after initial operations (say, one year) Gates are a formal review by a Gating Committee Gating Committees provide forums for evaluation and review of products, services, IT systems and infrastructure projects. Membership of committees is from the senior managers of the major stake-holders in projects (Stakeholders include user groups, maintainers etc).

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© 2005, Monash University, Australia For Systems Investment Gates for Products & Services Projects Gate 0: checks viability prior to Business Case Gate 1: examines Business Case Gate 2: technical, operational & support requirements prior to field trial Gate 3: assesses results of field trials Gate 4: assesses project launch & sets up post-implementation review Gate 5: assesses ongoing life cycle Gates for IT projects over $0.5M over 3 years. Gate 0: business concept, business drivers and deliverables Gate 1: Business Case Gate 2: technical design, analysis & planning Gate 3: pre-deployment review Gate 4: deployment plan, and post-implementation review Gate 5: reviews necessity and decommissioning option Similar approaches used for Network Infrastructure and other major projects

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© 2005, Monash University, Australia Summary Investment Decision Techniques are widely used to determine which (if any) projects go ahead. Management must ensure that funds and other resources are expended to best advantage of organisation Main financial methods used for screening and ranking of projects are: Nett Present Value (NPV) - a discounted cash flow (DCF) approach Internal Rate of Return (IRR)- DCF applied differently Payback Period - older approach, falling from favour Lease or buy comparisons Other aspects considered are risk and philosophies Once started, projects should have regular Evaluation and Review stages, such as the Telstra Gating procedures

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