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Managing Finance and Budgets Seminar 7

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Follow-up Activities Read Chapter 14 (including EPNV) Describe key concepts: Purpose of Investment Appraisal Accounting Rate of Return Payback Period Discounted Cash Flow Internal Rate of Return Cost-benefit analysis Exercises 14.1 and 14.2

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Questions 1 What precisely is meant by ‘Investment’? Give the full names of the following tools for analysing the value of an investment, ARR PP NPV IRR

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Methods of investment appraisal Four methods of evaluation: Accounting rate of return (ARR) Payback period (PP) Net present value (NPV) Internal rate of return (IRR)

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Questions 2 Explain the difference between ARR and PP, Explain why ARR is thought to be the more useful measure.

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Average annual profit________ x 100% Average investment to earn that profit ARR = Accounting rate of return (ARR)

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Payback period (PP) The payback period is the length of time it takes for the initial investment to be repaid out of the net cash inflows from the project.

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The cumulative cash flows of project with different types of yield Project 1 Project 3 Project 2 Yr 1 Cash flows (£000) 200 800 600400 900 0 500300 100 700 Yr 2 Yr 3 Yr 5 Yr 4 Yr 1 Yr 2 Yr 3 Yr 5 Yr 4 Yr 1 Yr 2 Yr 3 Yr 4 Yr 5 Yr 1 Payback period

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Questions 3 Explain why the value of £1000 invested and returned in five year’s time may not be equal to its present value. State three factors which need to be taken into account in calculating the discount rate used to determine the Net Present Value. Carry out the calculations to work out the net present value of £1 in 1 year, 2 years, 3 years, 4 years and 5 years time. M & A Exercise 14.1

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Interest foregone Inflation Discount rate Risk premium The factors influencing the discount rate to be applied to a project

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Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent (1 + 0.2) 0 (1 + 0.2) 5 (1 + 0.2) 4 (1 + 0.2) 1 (1 + 0.2) 2 (1 + 0.2) 3 1.000 0.833 0.694 0.579 0.482 0.402 Year 12345 Present value of £1

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Questions 4 Why is NPV superior to ARR and PP? What factors affect the sensitivity of NPV calculations?

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Why NPV is superior to ARR and PP It addresses the following issues: The timing of the cash flows The whole of the relevant cash flows The objectives of the business

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Factors affecting the sensitivity of NPV calculations Operating costs Project NPV Financing cost Initial outlay Sales price Annual sales volume Project life

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Questions 5 Explain what is meant by IRR. Explain the relationship between IRR and NPV. M & A 14.2

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Internal rate of return (IRR) The internal rate of return is the discount rate, which, when applied to the future cash flows of a project, will produce an NPV of precisely zero.

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The relationship between the NPV and IRR methods NPV (£000) Rate of return (%) 10 20 30 40 50 60 70 0 10 2030 40 IRR

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Finding the IRR of an investment by plotting the NPV against the discount rate NPV (£000) Discount rate (%) £18,660 (positive) + - 0 GH NPV £23,490 (negative) 6% 15% F E D

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Questions 5 In addition to the IRR, PP, NPV and IRR analysis what other issues might affect a company’s decision to invest ? What is the relationship between risk and expected return?

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Dealing with questions relating to investment appraisal Some practical points Relevant costs Opportunity costs Taxation Cash flows and profit flows

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Relationship between risk and return Return (%) Risk Risk premium Risk- free rate

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Questions 6 Describe the stages that you would expect to go through in managing an investment project.

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Managing the investment decision Stage 1 Stage 2 Stage 3 Stage 4 Stage 5 Determine investment funds available Identify profitable project opportunities Evaluate the proposed project Approve the project Monitor and control the project

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