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1 Investment Appraisal Geoff Leese Sept 1999 revised Sept 2001, Jan 2003, Jan 2006, Jan 2007, Jan 2008, Dec 2008 (special thanks to Geoff Leese)

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2 Investment Appraisal n Capital Investment is crucial for long term survival, to give benefit over a number of years n On the balance sheet, this consists of fixed and current assets and current liabilities n Can be seen as on-going projects generating return and cash flow

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3 Categories of Capital Investment n Replacement of existing facilities ä Relatively low risk n Expansion of existing facilities ä Low risk, reliable estimating in familiar markets n New Project ä Risk increasing, unknown market or product n Research and development ä Highly uncertain outcomes in new areas n Welfare projects ä Required by legislation, benefits hard to measure

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4 Context and Control n Strategic planning ä Long term objectives n Management control ä Use of annual or longer plan cycles ä Capital budgeting techniques to plan best allocation and use of current resources to achieve aims n Operational control ä Short term routines

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5 Appraisal techniques n Payback Period ä Time taken for original cost to be recovered in cash flows n Accounting rate of return ARR ä % return achieved over project life (differing definitions) n Net present value NPV ä initial cost of project with future generated discounted cash flow n Internal rate of return IRR ä % return from project over lifetime in discounted cash flows

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6 Opportunity cost n When resources are limited, the benefit or income that is foregone as a result of a decision n Example: Not spending on new machinery, but updating the software. Opportunity cost of the software is the benefit from the new machinery n Such costs are not recorded in accounts, but very important in cost benefit analysis

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7 Payback n Simple measure of the number of years that it will take to recover your original investment from net cash flows that result n For example, a small, internal IS program to save costs: n Original investment£450 ä net cash inflows –Year 1£100running total cash flow £100 –Year 2£200£300 –Year 3£100£400 –Year 4£100£500 –Year 5£220£720 n Payback 3.5 years

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8 Time Value of Money n Preference for money to be received earlier and paid later n Worth more than similar amount received later, as earlier monies can be invested to earn interest over the receiving period n Similarly, cash paid later is worth less than similar sum paid earlier, as you can have the investment benefit for longer

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9 Judging Payback n Reasonable to assume that stakeholders prefer shorter pay back periods n But also need to consider post payback cash flows. How profitable will they be? n Does not consider profitability of the project as a whole n Pay back is unlike traditional accounting of profit and capital employed n Very simple to use n But ignores opportunity cost of amount of money initially may vary with that received between years n And does not consider time value of money

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10 Accounting Rate of Return ARR n Profits from the project are compared with the investment n Future profit flow considered, also depreciation n Compares average profit per annum, before interest and taxation with original cost n Variants use profit after interest and taxation and other measures n All methods acceptable, but need to ensure comparisons are of the same method n Complements ROCE by relating profits to initial capital investment n Does not consider time value of money

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11 ARR ä Original investment£450, Life of asset 5 years ä Assume no residual value and straight-line depreciation charge of £90 (no residual value) Net cash indepreciationprofit –Year 1£100£90£ 10 –Year 2£200£90£110 –Year 3£100£90£ 10 –Year 4£100£90£ 10 –Year 5£220£90£130 ä Average profit £54 per annum ä ARR as annual average profit flow/original cost = 12%

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12 Future value of money This is the compound interest formula which tells you the future value of what you are currently investing A n = P(1 + i) n A n = future amount invested in year n P = amount invested now, at time n = 0 i = interest rate n = number of years money is invested

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13 Rearranging for Investment Appraisal Future forecast cash flows need to be calculated in terms of today’s value. This is the opposite of compounding, known as discounting, seen by rearranging the compound interest formula P = A n / (1 + i) n

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14 Net present value NPV n Covers discounting and weighted average cost of funds n Difference between the present values of cash inflows and present value of cash outflows n If NPV positive, required rate of return likely, accept n If NPV zero, consider accepting if risk also acceptable n If NPV negative, project should be rejected

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15 NPV calculation ExampleExample Back to our example of a £450 IS investment Payback period 3.5 years, ARR 12% If opportunity cost happened to be 10% (that is we could have obtained 10% on another use of our money), estimated cash flows £ per year at present values are: 90.9 + 165.3 + 75.1 + 68.3 + 136.6 = £536.2 total over 5 years NPV = £536.2 - £450 = £86.2 The project gives 10% return, plus a surplus of £86.2 Go ahead Try this for 20% opportunity cost

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16 Internal Rate of Return Known as discounted cash flow (DCF) yield IRR is another rearrangement of the equation It is the interest rate that gives NPV = 0 when applied to the projected cash flow Our IS example, where r = IRR: 0 = -P +100/(1+r)+200/(1+r) 2 +100/(1+r) 3 +100/(1+r) 4 +220/(1+r) 5

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17 IRR n Find the discount rate which produces an NPV of zero n Do this by interpolation, graphing known values of NPV, trial and error or using Excel or financial software n If the discount rate is greater than the cost of capital – acceptable n If the discount rate is less than the cost of capital - reject

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18 Investigation n Look at Excel n Practice using NPV and IRR with the data we have used n Look at the help function, and practice with that data n You can use other spreadsheet, or Sage or other financial packages

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19 Which technique n Many large organisations use more than one, as each analyses and gives different information n Payback measures time capital at risk n ARR measures profitability n NPV and ARR both show stakeholder returns

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20 Cost Benefit Analysis n Much broader view than cash or profit based analysis, which are purely based on economics n Seeks to assess the economic and social advantages (benefits) and disadvantages (costs) of a project, then quantifies in monetary terms n Major importance in public sector

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21 Assessing social benefits n Not all easy to translate into monetary terms n Broad view of stakeholders may be necessary, such as society as a whole n Costs and benefits arise at different times n Which discount rate to use? n Specialist area, under much debate

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22 Audit of capital investments n Good practice - any capital project investment should be assessed when it has been commissioned and running for a while n Gives a feedback loop for project appraisal and selection, ensuring an improvement of the process by performing three functions: ä Improving the quality of investment decisions under consideration ä Improving the quality of future investment decisions ä Assist corrective action for current projects

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23 Further Reading n Dyson Chapter 19

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© 2009 Pearson Prentice Hall. All rights reserved. Capital Budgeting and Cost Analysis.

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