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©A. Ward 2002 Capital Expenditure Appraisal Cash Flow - revisited Accounting Rate of Return Payback Period DCF Techniques Net Present Value Sensitivity Analysis

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©A. Ward 2002 Cash Flow Profile Net Cash Flow Time Major long-term capital investment project.

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©A. Ward 2002 Cash Flow Profile Net Cash Flow Time Periodic replacement with increasing prices.

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©A. Ward 2002 Cash Flow Profile Net Cash Flow Time Investment with cyclical cash flows

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©A. Ward 2002 Capital Expenditure - Definition “Funds spent in the expectation of securing a stream of benefits, which may take some time to start flowing and which may last for some years.” The amount spent is very often substantial.

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©A. Ward 2002 Capital Expenditure - Examples Purchase of Plant or Machinery Purchase of Land Development of a New Product Installation of a New Computer System etc.

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©A. Ward 2002 Capital Expenditure Appraisal - Objectives whether a particular capital expenditure proposal is justified in terms of the expected benefits if there are alternative proposals which should be undertaken

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©A. Ward 2002 Analysis of Options - Example

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©A. Ward 2002 Accounting Rate of Return Surplus = Cash Inflow - (Initial Investment - Residual Value) Average Investment = (Initial Investment - Residual Value)/2

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©A. Ward 2002 Cash Inflow Stream Total net cash flow is identical Pattern of cash inflow is different There is less risk associated with cash received early, compared to that received later The earlier that cash is received the quicker it can be recycled into new cash generating ventures (or used to pay-off debts) Accounting Rate of Return ignores the time value of money.

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©A. Ward 2002 Payback Period (Breakeven) Recognises the time value of money

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©A. Ward 2002 Limitations Accounting Rate of Return - Ignores the time value of money Payback Period - Ignores cash after Breakeven There has to be a better way! There is!

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©A. Ward 2002 Discounted Cash Flow (DCF) Basic Principle is that the value of money changes with time. Example : £100 invested at 10% interest rate is worth £110 in 1 year, £121 Thus £100 now is worth just the same as £121 next year Based on Investment Criteria - ignore risk & inflation

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©A. Ward 2002 Discounted Cash Flow (DCF) Decision : Is it worth making a £100 “investment” now to generate a £130 of future value at the end of 2 years? To answer we need to make a Net Present Value calculation

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©A. Ward 2002 Net Present Value (NPV) Given an interest rate of 10% what investment now will give a future value of £130 in 2 years time? ? invested now is worth ?*(1+0.1) in 1 years time ?*(1+0.1) becomes worth ?*(1+0.1)*(1+0.1) in 2 years time Hence ?*(1+0.1)*(1+0.1) = £130 ? = £107.44

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©A. Ward 2002 Net Present Value (NPV) In General The Net Present Value of a return of £P in n years time with a prevailing interest rate of r% is given by: Solve by spreadsheet or Discount Tables Note this ignores future inflation rates. The model allows for varying interest rates per year.

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©A. Ward 2002 Discount Factors

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©A. Ward 2002 Net Present Value of a Cash Stream To handle a regular or periodic cash stream (in or out): Determine the periodic cash flow Convert each cash flow to the net present value Sum all present values to give Net Present Value of Stream

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©A. Ward 2002 NPV Example

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©A. Ward 2002 NPV Example

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©A. Ward 2002 Sensitivity Analysis Capital Expenditure Proposals involve assumptions Each Assumption can be tested The sensitivity of the IRR or NPV can be determined for each assumption

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©A. Ward 2002 Sensitivity Analysis - Example Consider a +/-10% change in initial cost of project

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©A. Ward 2002 Sensitivity Analysis - Example Consider the effect of a year delay in sales Or 1 year delay in entire project

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©A. Ward 2002 Sensitivity Analysis - Example Consider interest rate changes

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