1. FINA1129 Corporate Financial Management
Welcome to
FINA1129 Corporate Financial Management
Dr. Lianfeng Quan
Senior Lecturer in Accounting and Finance
Room 006, Queen Anne Court

2. FINA1129 Corporate Financial Management
Lecture 2
Investment Appraisal Methods I

3. Essential Readings:
Watson and Head Chapter 6
Glen Arnold Chapter 4

4. Learning Objectives By the end of this session, you will be able to:
Understand what is investment and investment appraisal.
Understand the concept of time value of money.
Application of two investment appraisal techniques.
Return on Capital Employed (ROCE)
Payback Period (PBP)
Understand the advantages and disadvantages of the ROCE and PBP

5. Why Investment? Objective: create value for a firm owners.
Shareholders provide funds to a firm to invest in assets.
Management will employ the best investment appraisal techniques available that will give the best return.

6. Investment Appraisal
A means of assessing whether an investment project is worthwhile or not
Investment assumes that the investment will yield future income streams
Investment appraisal is all about assessing these income streams against the cost of the investment

7. Key Concept: Time Value of Money
Consuming Today or Tomorrow
People prefer to consume goods today rather than wait to consume similar goods tomorrow.
Money has a time value because a pound today is worth more than a pound tomorrow.
Today’s pound can be invested to earn interest.
Value of a pound invested grows over time.
Rate of interest determines trade-off between spending today versus saving.

8. Time-Value of Money (Cont.)
The value of money changes over time
£100 receive today is not the same as £100 receive in one year’s time
Three factors
Time (spend money or invest)
Inflation (purchasing power)
Risk (possible non-payment)

9. Future Values: Simple Interest
A sum of £10 is deposited in a bank account that pays 12 per cent per annum. At the end of year 1
FV = PV(1 + i) = £10( ) = £ where FV = Future value, PV = Present value, i = Interest rate.
At the end of five years: FV = ?
=PV(1 + i × n) = £10( × 5) =16
where n = number of years.

10. Future Values: Compounding
Future values are found by compounding interest forward through time.
FV = PV (1 + i)n
Where FV = future value
PV = present value
i = interest rate
n = number of years over which compounding takes place
Deposit £100 in a bank account paying interest at 8 per cent per annum, after three years:
FV = 100 ( )3 = £125.97
100(1+0.08)=108
108(1+0.08)=116.64
116.64(1+0.08)=125.97

11. Future Value Exercise
Invest £100 now at 5% interest per year for the next two years. What will the future value of the £100 be in two years?
FV = PV×(1 + i)n
£100×(1+5%)2 = £110.25
After 1 year: £ (100 × 1.05)
After 2 years: £ (105 × 1.05)

12. Formula for Compounding More Than Once A Year
Compounding an investment m times a year provides end-of-year wealth of: where PV is the initial investment and i is the stated annual interest rate, or nominal annual interest rate.

13. Compounding More Than Once a Year Example
What is the end-of-year wealth if Jane Christine receives a stated annual interest rate of 24 percent compounded monthly on a €1 investment?
FV = PV (1 + i)n

14. Present Values: Discounting
The method to find a present value is called discounting.
Deposit £100 in a bank account paying interest at 8 per cent per annum, after three years:
FV = 100 ( )3 = £125.97
How much must I deposit in the bank now to receive £ in three years?
Present value factor FV 1
(1 + i)n
PV =
or FV ×
(1 + i)n
125.97
PV =
= 100
( )3

15. Discounting Example PV £20,000
How much would an investor have to set aside today in order to have £20,000 five years from now if the current rate is 15%? PV
£20,000 1 2 3 4 5

16. Discounting Exercise
What sum of money invested now at 5% will give £120 in 2-years’ time?
This will be £120/1.052 =£108.84
or £120 x (1/1.05)2= £120 x 0.907= £
This is the present value of £120 received in 2 years, if your required rate of return is 5%.
Present value factor

17. Compounding and Discounting
Compounding takes forward the current value of an investment to its future value.
FV = PV (1 + i)n
Discounting takes backward the future value of cash-flow to its present value. FV 1
(1 + i)n
PV =
or FV ×
(1 + i)n

18. FV and PV with Different Interest Rate
FV = PV (1 + i)n

19. Investment Appraisal Methods
Non-discount
Return on Capital Employed (ROCE)
Payback Period (PBP)
Discount Cash-flow (DCF)
Net Present Value (NPV)
Internal Rate of Return (IRR)

20. Return on Capital Employed (ROCE)
Return on investment or accounting rate of return.
Relates accounting profit to the capital invested.
Simple decision rule: accept project if ROCE is equal to or greater than target value i.e. current company or division ROCE. %

21. ROCE (Cont.)
Average annual accounting profit can be calculated from before tax operating cash flows by taking off depreciation.
Depreciation is the part of the original cost of a fixed asset that is consumed during its period of use by the business.
Depreciation is an expense. It needs to be charged to the profit and loss account.
Accounting profit is not cash flow.

22. Asset life (Number of years)
Calculating Annual Depreciation Charge
Year 1
Year 3
Year 2
Year 4 and so on
Depreciation
less
Residual value
equals
Cost of the asset
Depreciable amount
Asset life (Number of years)

23. Straight Line Method
The depreciation charge, once calculated, remains the same for every year of the asset’s life.

24. Straight Line Method: Example
If a lorry was bought for £22,000, would be kept for four years, and then be sold for £2,000, the depreciation to be charged each year would be:
Cost (£22,000) – Estimated disposal value (£2,000)
Number of expected years of use (4)
= £5,000 depreciation each year for four years.

25. ROCE – Calculation Example
A project entails an initial investment of £200,000 for a machine. Over five years net cash flows of £60,000pa are generated. The scrap value of the machine at the end of 5 years is £50,000. Calculate the ROCE.

26. A project entails an initial investment of £200,000 for a machine
A project entails an initial investment of £200,000 for a machine. Over five years net cash flows of £60,000pa are generated. The scrap value of the machine at the end of 5 years is £50,000. Calculate the ROCE.
Average Annual Profit = (Total cash flow generated – Total depreciation) / the life of the project = (£300,000 - £150,000)/5 = £30,000. Average Investment (£200,000 + £50,000)/2 = £125,000 ROCE = £30,000/£125,000 X 100% = 24%

27. ROCE Exercise A machine costs £10 000 Useful economic life is 5 years
After 5 years, scrap value of £2000
Net cash inflows from the machine would be £3000 per year
Ignore taxation.

28. ROCE Exercise Solution
A machine costs £10 000
Useful economic life is 5 years
After 5 years, scrap value of £2000
Net cash inflows from the machine would be £3000 per year
Ignore taxation.
Solution:
Depreciation: (10000 – 2000)/5 = £1600
Average annual profit: 3000 – 1600 = £1400
Average investment: ( )/2 = £6000
ROCE: (1400/6000) × 100% = 23%

29. ROCE Advantages Simple to calculate.
Uses profits which may be seen in the financial accounts.
Gives a percentage measure which may be more readily understood by management.

30. ROCE Disadvantages Ignores the time value of money.
Profits are arrived at after taking accruals and provisions into account. However, only actual cash flows increase shareholders' wealth.
Relative measure and so ignores size of initial investment.

31. Illustration of how ROCE, which uses average accounting profit, ignores the timing of project cash flows
5625
5625

32. Payback Period
The number of years needed to recover the original investment.
Time for initial outflow to be recouped
Cash outflow
Cash inflows
The decision rule is to accept a project if the payback period is equal to or less than a stated target value.

33. Computing The Payback Period
To compute the payback period, we need to know the project’s cost and estimate its future net cash flows

34. Payback Period Example
Project X Y Z Year £ £ £ 0 (200) (300) (400) Payback Using the payback method project Z will be chosen as the payback period is only 1 year.
2 years
2.5 years
1 year

35. Payback Advantages Simple concept to understand.
Easy to calculate (provided future cash flows have been calculated).
Takes risk into account (in the sense that earlier cash flows are more certain). The more quickly you recover the cash, the less risky is the project.
The payback period may also be used as an indicator of project liquidity.
Uses cash, not accounting profit.

36. Payback Disadvantages
Considers cash flows within the payback period only; says nothing about project as a whole.
Ignores size and timing of cash flows.
Ignores time value of money (although discounted payback can be used).

37. Payback Disadvantages (Cont.)
It does not really take account of risk.
It is a measure of payback and not a measure of profitability.

38. Recap of Lecture 2
Understand what is investment and investment appraisal.
Understand the concept of time value of money.
Application of two investment appraisal techniques.
Return on Capital Employed (ROCE)
Payback Period (PBP)
Understand the advantages and disadvantages of the ROCE and PBP

39. Next Lecture
Apply discounted cash flow investment appraisal techniques.
Net Present Value (NPV)
Internal Rate of Return (IRR)
Profitability Index (PI)
Understand the advantages and disadvantages of NPV, IRR and PI.
Justify using NPV as the preferred criterion for evaluating investment projects.