Chapter 6: An Economic Appraisal Technique: PBP and ARR

1. Chapter 6: An Economic Appraisal Technique: PBP and ARR Kim, GT IE of Chosun University

2. The Purpose of An Economic Appraisal • An economic appraisal is a vein to accomplish a corporate objective. • In other words, it is commensurate with evaluating the corporate strategies so as to improve stockholders’ wealth by implementing a most desirable projects. • The types of investment projects; • i) service (cost) projects: those which are with regard to reducing costs. • (ex. A power plant may need to decide one fuel resource to generate electricity between gas and oil.) • ii) revenue projects: those which are concerned with increasing a firm’s revenue.(ex. A company may need to decide which one to produce to increase its profit or revenue between a HD and plain tv) • All projects need cash outflows at the outset and generates cash inflows in the following times. Kim, GT IE of Chosun University

3. Appraisal Techniques • Depending on whether or not the interest concept is involved. - Appraisal techniques without interest involved. (1) payback period(PB) (2) accounting rate of return(ARR) - Appraisal techniques with interest involved. (1) net present value(NPV) (2) annual equivalent value(AE) (3) internal rate of return(IRR) Kim, GT IE of Chosun University

4. Appraisal Techniques • Depending on the final value of the results which are provided by the appraisal techniques - appraisal techniques with an absolute value i) conventional & discounted PB ii) NPV iii) AE - appraisal techniques with a relative value i) ARR ii) IRR Kim, GT IE of Chosun University

5. The Utilization of the Appraisal Techniques PER: price-earning ratio, G: growth, NG: no-growth, H: hight, L: low, Y: yes, N: no, M: a manufacturing industry, NM: a non-manufacturing industry, IRR: internal rate of return, NPV: net present value, PB: payback period, MARR: minimum attractive of return, SA: sensitivity analysis, DPB: discounted payback period, ROA: real options approach, ARR: accounting rate of return, SA**: simulation analysis, APV: adjusted present value, PI: profitability index Kim, GT IE of Chosun University

6. Payback Period • Principle - To be a period of time spent to fully recover the initial investment cost • Method - It is determined based on the cumulative amount of cash flows. A PB is found to be one which satisfies the equation above. • Decision Criteria - If A PB is less than the predetermined period of time, undertake the project and perform the following sophisticated evaluation techniques. Otherwise, reject it. • The Types of PB i) Traditional payback period(TPBP): no interest concept considered. ii) Discounted payback period (DPB): interest concept considered. Kim, GT IE of Chosun University

7. Traditional Payback Period (unit: 000 won) N CFCCF -30,000 9,000 9,000 9,000 9,000 9,000 -30,000 -21,000 -12,000 -3,000 6,000 15,000 0 1 2 3 4 5 A TPBP is determined between 3 and 4 years. TPBP= 3.33 years Kim, GT IE of Chosun University

8. A Conventional Payback Period (unit: 000 won) Kim, GT IE of Chosun University

9. A Conventional Payback Period Ex6.1] Determine a TPBP Given] The initial investment costs of project A and B: 120 m won and150 m won A project life of A and B are 3 and 7 years Kim, GT IE of Chosun University

10. Discounted Payback Period • Principle - TPBP + Interest Concept Employed • Decision Criteria - To be one which makes a cumulative cash flow zero - NPV=0  Equation Kim, GT IE of Chosun University

11. 33,982 82,013 33,726 33,205 33,135 n 0 1 2 3 4 5 Unit: ooo won 62,500 DPBP Ex6.2] Determine a discounted payback period for the project for an automatic machining center Given] Cash flows for the project, interest rate=15% Kim, GT IE of Chosun University

12. DPBP Sol] determine a DPBP *: Cumulative Cash Flow without considering an interest rate **: Discounted Cash Flow= NCF * Interest Factor ***: Cumulative Discounted Cash Flow Kim, GT IE of Chosun University

13. A A A A A N 3 4 1 2 ………………………… 0 i P A Relationship Between PB and ROR where, P: present value, A: equal amount of a cash flow N: project life, i: interest rate Kim, GT IE of Chosun University

14. A Relationship Between PB and ROR if a project life is infinite, i.e., “ ” , The equation above is called a capitalized equivalent (CE). - A relationship between a PB and IRR Kim, GT IE of Chosun University

15. When The Payback Period Technique Can Be Properly Used: It is better to use for a case in which the project life is measured in a month rather than a year. Ex6.3]A adequate Case for A Traditional Payback Period Given] A investment cost for installing a heating and air conditioning system in the class: May=3.375m won, Jun=1.125m won, a cost saving of electricity: Jun. to Aug. =450, 000 won, Apr. to May & Sep to Oct=225,000 won, Nov. to Mar=337,000 won Sol] Determine a traditional payback period (unit: 000 won) PBP15.25months Kim, GT IE of Chosun University

16. A Risk Measuring with A Payback Period Ex6.4]Measure Risk with a Payback Period Given] A investment cost for installing a heating and air conditioning system in the class: May=3.375m won, Jun=1.125m won, a cost saving of electricity: Jun. to Aug. =450, 000 won, Apr. to May & Sep to Oct=225,000 won, Nov. to Mar=337,000 won , Interest Rate =12% Sol] Determine a discounted payback period (unit: 000 won) • Project Balance: PB 투자회수기간 16.47개월 Kim, GT IE of Chosun University

17. A Risk Measuring with A Payback Period Kim, GT IE of Chosun University

18. Accounting Rate of Return Ex6.6] Determine an ARR with an average investment capital Given] I: 500 m won, life: 5years, No salvage value at the end of year 5: 0, The relevant financial date Kim, GT IE of Chosun University

19. Accounting Rate of Return - Step 1: derive an after-tax average income - Step 2: determine an average investment capital - Step 3: Determine an ARR Kim, GT IE of Chosun University