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C APITAL I NVESTMENT A PPRAISAL : A PPRAISAL PROCESS AND METHODS Objectives: Describe the nature of capital investment appraisal Apply the main investment appraisal techniques Recognise the limitations of investment appraisal technique 1

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D EFINITION OF I NVESTMENT 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 2

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T YPES OF CAPITAL INVESTMENT Replacement of obsolete assets Cost reduction e.g. IT system Expansion e.g new building & equipment Strategic proposal: improve delivery service, staff training. Diversification for risk reduction 3

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N EED FOR I NVESTMENT A PPRAISAL Large amount of resources are involved and wrong decisions could be costly Difficult and expensive to reverse Investment decisions can have a direct impact on the ability of the organisation to meet its objectives 4

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I NVESTMENT A PPRAISAL P ROCESS Stages: identify objectives. What is it? Within the corporate objectives? Identify alternatives. Use CAD, CAM or use external service. Collect and analyse data. Examine the technical and economic feasibility of the project, cash flows etc. 5

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I NVESTMENT A PPRAISAL P ROCESS Stages: decide which one to undertake authorisation and implementation review and monitor: learn from its experience and try to improve future decision - making. 6

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A PPRAISAL M ETHODS Payback method - length of time it takes to repay the cost of initial investment 7 1. Discounted Cash Flow (DCF) Criteria Net Present Value (NPV) Internal Rate of Return (IRR) Profitability Index (PI) 2. Non-discounted Cash Flow Criteria Payback Period (PB) Discounted Payback Period (DPB) Accounting Rate of Return (ARR)

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P AYBACK 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.

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P AYBACK M ETHOD 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 1255,000 Year 2255,000 Year 3255,000 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 + 255,000 = 510,000 = 2 years & some months…. 600,000 - 510,000 = 90,000 still owing 255,000 = 21,250 12 months = 90,000 = 4.235 month 21,250 = 2 years and 5 months…

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P AYBACK P ERIOD Lecture Example 1 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. 10

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P AYBACK P ERIOD Solution 2.1 YearYearly cash flow cumulative net cash flow £ £ 0(30,000) (30,000) 19,000 (21,000 29,000 ( 12,000) 39,000 (3,000) 49,000 6,000 59,000 15,000 Therefore 3years = 27,000 then 3000/9000 x 12 = 4 Payback period = 3 years 4months 11

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E XAMPLE 2. 12

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E XAMPLE 2. SOLUTION a) Undiscounted pay back For A = 4 years For B = 5 years 13

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DISCOUNTED PAY BACK METHOD Takes into account the fact that money values 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 Shows you what your investment would have earned in an alternative investment regime

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P RESENT V ALUE The principle of discounting: How much would you have to invest now to earn £100 in 1 years 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.

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P RESENT V ALUE Future Value PV = ----------------- (1 + i) n Where i = interest rate n = number of years The Present Value of £1 @ 10% in 1 years time is 0.9090. If you invested 0.9090p today and the interest rate was 10% you would have £1 in a years time Process referred to as: ‘Discounting Cash Flow’

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P RESENT V ALUE 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.6595373 = £329.77 £329.77 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! )

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E XAMPLE 2.2 SOLUTION 18

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E XAMPLE 2.2 SOLUTION For A, payback is outside the project’s life For B payback is 6.25 years Choose B 19

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A DVANTAGES AND DISADVANTAGES OF PAYBACK Certain virtues: Simplicity Cost effective Short-term effects Risk shield Liquidity Serious limitations: Cash flows after payback Cash flows ignored Cash flow patterns Administrative difficulties Inconsistent with shareholder value Read separate handout 20

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E XTRA EXERCISES …. Invest £600k Y1 = 100, Y2 = 400, Y3 = 400 Y4 = 180 Payback ARR Payback = 2 years & ??? Months Y3 400/12mths = £33.33 so need to repay 100 in 3 rd year so in 2 years and 4 months

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EXERCISES Invest £600k Y1 = 100, Y2 = 400, Y3 = 400 Y4 = 180 Payback = 2 years & ??? Months Y3 400/12mths = £33.33 so need to repay 100 in 3 rd year so in 2 years and 4 months ARR = 1080 – 600 = 480 / 4 years = 120 /300 = 0.4 x 100 = 40%

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A CCOUNTING R ATE OF R ETURN (ARR) 23

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A CCEPTANCE R ULE This method will accept all those projects whose ARR is higher than the minimum rate established by the management and reject those projects which have ARR less than the minimum rate. This method would rank a project as number one if it has highest ARR and lowest rank would be assigned to the project with lowest ARR.

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L ECTURE E XAMPLE 25

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E XAMPLE 2.3 - SOLUTION Average Accounting Profit (- 250 +1000 + 1000 + 20,750) / 4 = 5625 Average investment = 45,000 / 2 = 22500 ARR = (5625/22,500 x 100 = 25% 26

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E VALUATION OF ARR M ETHOD The ARR method may claim some merits Simplicity Accounting data Accounting profitability Serious shortcoming Cash flows ignored Time value ignored Arbitrary cut-off

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N ET PRESENT VALUE Net Present Value (NPV) - the difference between the present values of cash inflows and outflows of an investment Opportunity cost of undertaking the investment is the alternative of earning interest rate in the financial market. 28

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NPV 29

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D EFINITIONS Present value:- the amount of money you must invest or lend at the present time so as to end up with a particular amount of money in the future. Discounting: -finding the present value of a future cash flow 30

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C ALCULATING N ET P RESENT V ALUE Assume that Project X costs Rs 2,500 now and is expected to generate year-end cash inflows of Rs 900, Rs 800, Rs 700, Rs 600 and Rs 500 in years 1 through 5. The opportunity cost of the capital may be assumed to be 10 per cent.

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A CCEPTANCE R ULE Accept the project when NPV is positive NPV > 0 Reject the project when NPV is negative NPV < 0 May accept the project when NPV is zero NPV = 0 The NPV method can be used to select between mutually exclusive projects; the one with the higher NPV should be selected.

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E XAMPLE 2.4 A company can purchase a machine at the price of £2200. The machine has a productive life of three years and the net additions to cash inflows at the end of each of the three years are £770, £968 and £1331. The company can buy the machine without having to borrow and the best alternative is investment elsewhere at an interest rate of 10%. Evaluate the project using the a) Net present value method. b) Internal rate of return 33

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E XAMPLE 2.4: SOLUTION 34

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N ET P RESENT V ALUE Lecture Example 2.5 A firm invest £180,000 in a project that will give a net cash inflow of 50,000 in real terms in each of the next six years. Its real pre-tax cost of capital is 13%. Required: Calculate NPV 35

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N ET P RESENT V ALUE Solution 2.5 Year Cash FlowPV factor 13% Present value 0(180,000)1.00(180,000) 1 50,0000.88544,250 2 50,0000.78339,150 3 50,0000.69334,650 4 50,0000.61330,650 5 50,0000.54327,150 6 50,0000.48024,000 NPV 19,850 Positive NPV indicates viability of the project. Negative NPV indicates non-viability of the project. 36

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A LTERNATIVE SOLUTION TO 2.5 Use the annuity table YearCash flowDF @13% PV 0(180,000)1(180,000) 1-650,000 3.998199,900 NPV 19,900 37

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E VALUATION OF THE NPV M ETHOD NPV is most acceptable investment rule for the following reasons: Time value Measure of true profitability Value-additivity Shareholder value Limitations: Involved cash flow estimation Discount rate difficult to determine Mutually exclusive projects Ranking of projects

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I NTERNAL R ATE OF R ETURN M ETHOD The internal rate of return (IRR) is the rate that equates the investment outlay with the present value of cash inflow received after one period. This also implies that the rate of return is the discount rate which makes NPV = 0.

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C ALCULATION OF IRR Uneven Cash Flows : Calculating IRR by Trial and Error The approach is to select any discount rate to compute the present value of cash inflows. If the calculated present value of the expected cash inflow is lower than the present value of cash outflows, a lower rate should be tried. On the other hand, a higher value should be tried if the present value of inflows is higher than the present value of outflows. This process will be repeated unless the net present value becomes zero.

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C ALCULATION OF IRR Level Cash Flows Let us assume that an investment would cost Rs 20,000 and provide annual cash inflow of Rs 5,430 for 6 years. The IRR of the investment can be found out as follows:

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IRR 42

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E XAMPLE 2.6 Using Lecture example 2.4 (above), calculate the internal rate of return for the project. 43

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I NTERNAL R ATE OF R ETURN Solution to 2.6 IRR Try 15% Year Cash flow Discount Factor (15%) PV 0(2200)1.000(2200) 1 7700.869669.59 2 9680.756131.90 313310.657575.13 NPV 76.62 44

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I NTERNAL R ATE OF R ETURN Year Cash flow DC (16%) PV 0 (2200)1.000(2200) 1 7700.8621663.83 2 9680.7432719.42 3 13310.6407 852.77 NPV 36.01 45

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IRR Year Cash flow DCF (17%) PV 0(2200) 1.000(2200) 1 770 0.8475652.58 2 968 0.7305711.48 31331 0.6244831.08 NPV (4.86) Interpolation 16 + 36.01 / 40.87 = 16.88% 46

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47 Financial Management, Ninth Edition © I M Pandey Vikas Publishing House Pvt. Ltd. NPV P ROFILE AND IRR

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48 A CCEPTANCE R ULE Accept the project when r > k. Reject the project when r < k. May accept the project when r = k. In case of independent projects, IRR and NPV rules will give the same results if the firm has no shortage of funds.

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49 E VALUATION OF IRR M ETHOD IRR method has following merits: Time value Profitability measure Acceptance rule Shareholder value IRR method may suffer from: Multiple rates Mutually exclusive projects Value additivity

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50 P ROFITABILITY I NDEX Profitability index is the ratio of the present value of cash inflows, at the required rate of return, to the initial cash outflow of the investment.

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P ROFITABILITY I NDEX The initial cash outlay of a project is Rs 100,000 and it can generate cash inflow of Rs 40,000, Rs 30,000, Rs 50,000 and Rs 20,000 in year 1 through 4. Assume a 10 per cent rate of discount. The PV of cash inflows at 10 per cent discount rate is:

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52 A CCEPTANCE R ULE The following are the P I acceptance rules: Accept the project when PI is greater than one. PI > 1 Reject the project when PI is less than one. PI < 1 May accept the project when PI is equal to one. PI = 1 The project with positive NPV will have PI greater than one. PI less than means that the project’s NPV is negative.

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53 E VALUATION OF PI M ETHOD It recognises the time value of money. It is consistent with the shareholder value maximisation principle. A project with PI greater than one will have positive NPV and if accepted, it will increase shareholders’ wealth. In the PI method, since the present value of cash inflows is divided by the initial cash outflow, it is a relative measure of a project’s profitability. Like NPV method, PI criterion also requires calculation of cash flows and estimate of the discount rate. In practice, estimation of cash flows and discount rate pose problems.

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A PPRAISAL M ETHODS Please read more on the advantages and disadvantages of these techniques Why is the NPV considered superior over the other methods, even the IRR? 54

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