1 Intro to Financial Management of the Organisation Week 9 Capital Investment Appraisal

2 If a company is going to invest in a project it need to ensure The project will be financially viable It will be successful Risk levels will be minimised

3 Discount or not? We will consider 4 methods of decision making for capital projects Each method can be used to Make comparisons between projects competing for scarce resources Make comparisons between a project and a company benchmark 2 methods employ discounting 2 do not

4 Company scenario Verminous Ltd (cost of capital = 10%) Verminous Ltd are contemplating the purchase of a new machine. They have a choice of either the "Weasel" or the "Stoat". The company has made some estimates of costs and expected cash inflows and this is rovided below: WeaselStoat £,000£,000 Cost of Machine Cash inflows Year Year Year Year Year Year 6 60 Profit160240

5 Payback Period (PP) The payback period Is the period of time required for the cumulative expected cash flows from an investment project to equal the initial cash outflow This method computes the amount of time required to recover the initial investment The acceptance criterion is dependent upon the maximum cutoff period established by management for projects of a similar type

6 Pros and Cons of PP Advantages Easy to use and understand Can be used as a measure of liquidity Easier to forecast short term than long term cashflows Disadvantages Does not account for time value of money*** Does not consider cashflows beyond the payback period The cutoff period is subjective

7 Weasel & Stoat cumulative cumulative Year Year Year Year Year Year 660 Weasel = 4yrs 1/6 th (4 yrs 2 months) Stoat = 3 yrs 7/8 th (3 yrs 10.5 months)

8 A PP conundrum M1M2M3 Cost of machine Yr 1 cashflow Yr 2 cashflow Yr 3 cashflow Yr 4 cashflow Yr 5 cashflow What is PP? PP = 3 years for each

9 Accounting Rate of Return (ARR) This technique is similar to ROCE ratio you are familiar with Remember, ROCE can be used as a measure of management efficiency How effectively can management make profit (return) from capital in the business (capital employed)

10 Accounting Rate of Return (ARR) All other appraisal techniques are concerned with NET cashflows ie cash generated less cash costs ARR considers Accounting Profit as the measurement Accounting Profit = Income less all costs incurred in generating that income, therefore includes depreciation

11 Accounting Rate of Return (ARR) ARR = Average annual profit X 100 Average Investment Average annual profit = total profit for project / number of years Average Investment = (Capital cost + residual value) / 2

12 So, applying it to Weasel & Stoat WeaselStoat Total dep'n Year Year Year Year Year Year 6 60 Total profit

13 Which means.. There is no residual value, so full cost is depreciated. Average Annual Profit = (Total Net cashflows – Full cost of asset) / years of project Again, as no RV average investment = Cost/2 Weasel(160/6)/200*100 =13% Stoat(240/5)/300*100 =16%

14 ARR and ROCE Assume Verminous Ltds ROCE is 14% If Weasel were chosen it would reduce (if only marginally) the companys ROCE If Stoat were chosen it would, of course, increase ROCE In this case higher ARR = project with higher profit But what is most important Profits or ROCE? Assume Verminous has ROCE of 12%...

15 ARR a conundrum WeaselStoat Total depreciation Year Year Year Year Year Year 6 60 Total profit ARR Av profit(160/6) 27 (170/5)3413% (W) Av Investment % (S)

16 Pros & Cons of ARR Advantages generally accepted provides index of performance encourages managers to improve ARR can be used to gauge performance & make comparisons Disadvantages lack of consensus on definitions of capital or profit can be manipulated can distort overall allocation of resources noncash items included ignores the timing of cash flows

17 Discounting methods Both PP and ARR assume absolute values in cashflows The value of a cashflow today = the same as its value in 5 or 6 years time There is no consideration of risk involved (cashflows are estimates!) They assume the capital used is costless Apart from the projects they assume there is no alternative use for the capital (ie invest it)

18 A question.. Let us suppose you were given the choice of receiving £10,000 today or £10,000 in 3 years time. Which would you choose?

19 Discounting cashflows The value of that £10,000 today can be measured as £10,000 plus the potential value of interest earned. If you were to receive your cash in 3 years time, then, you would expect to receive not just £10,000 but an additional sum for the interest receivable over that time period. Conversely the value today of that £10,000 plus interest received in 3 years, would simply be £10,000.

20 Graphically represented

21 Calculating Future Value (FV) By applying interest at a given rate to the £10,000 we can calculate what it would be worth in n years time But how can we calculate the present value of a sum receivable in n years time? Take option (A), assume you can get 4.5% interest on your £10,000 The future value of the £10,000 after 1 year would be £10,450, which of course is calculated by multiplying the principal amount of £10,000 by the interest rate of 4.5% and then adding the interest gained to the principal amount: Future value of investment at end of first year: = (£10,000 x 0.045) + £10,000 = £10,450

22 Calculating Future Value (FV) You can also calculate the total amount of a one-year investment with a simple manipulation of the above equation: Original equation: (£10,000 x 0.045) + £10,000 = £10,450 Manipulation: £10,000 x [(1 x 0.045) + 1] = £10,450 Final equation: £10,000 x ( ) = £10,450

23 Calculating Future Value (FV) Take the £10,450 and multiply it again by ( ). At the end of two years, you would have £10,920: Future value of investment at end of second year: = £10,450 x ( ) = £10, The above calculation, then, is equivalent to the following equation: Future Value = £10,000 x ( ) x ( ) We can simplify this equation as follows: Future Value = £10,000 x ( ) (1+1) = £10,000 x ( ) 2 = £10,920.25

24 Working Back Present Value (PV) Formula

25 PV Calculation Applying this to option B Present Value= £10,000 x ( ) -3 = £8, The present value of a future payment of £10,000 is worth £8, today if interest rates are 4.5% per year That is choosing option B is like taking £8, now and then investing it for three years.

26 The easier option The concepts of using FV and PV will be used again in looking at dividend valuations But, to simplify….. Present Value Tables

27 Net Present Value The essence of a business is to maximise shareholder wealth If raw cashflows are considered it is possible that an apparent increase in wealth could actually result in a diminution

28 Application to Weasel & Stoat WeaselStoat 10% PV Year Year Year Year Year Year NPV =4.97NPV = 5.63

29 Comparison of results The 2 machines both have POSITIVE NPVs But only just… It is up to management to decide if the factors incorporated in the Discount Rate are sufficient to accept the project with the higher NPV

30 Internal Rate of Return (IRR) The application of Present Values to the cashflows shows that the actual rate of return must be >10% In some instances management would want to know the exact rate of return We can find this by formula

31 Internal Rate of Return (IRR) Ideal Scenario By trial & error calculate Negative NPV As 10% gives Positive NPV Choose a higher Discount Rate In this case 11% should do Apply DF to cashflows & determine NPV Then apply formula

32 IRR Formula IRR = A + C (B – A) C – D Where: A = discount rate of low trial B = discount rate of high trial C = NPV of low trial cashflow D = NPV of high trial cashflow

33 Weasel & Stoat WeaselStoat 11% Year Year Year Year Year Year NPV = -6.71NPV =-12.37

34 Weasel & Stoat Outcomes Weasel IRR = 10 + [4.97/( )]* = 10.43% Stoat IRR = 10 + [5.63/( )]* = 10.31%