Lecture 2- Capital Investment Appraisal: Appraisal process and methods

1. Lecture 2- Capital Investment Appraisal: Appraisal process and methods Objectives: • Describe the nature of capital investment appraisal • Apply the main investment appraisal techniques • Recognise the limitations of investment appraisal technique

2. Definition of Investment • 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

3. Types 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

4. Need for Investment Appraisal • 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

5. Investment Appraisal Process 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.

6. Investment Appraisal Process Stages: • decide which one to undertake • authorisation and implementation • review and monitor: learn from its experience and try to improve future decision - making.

7. Appraisal Methods Payback method - length of time it takes to repay the cost of initial investment

8. Payback Period Lecture Example 2.1 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.

9. Payback Period Solution 2.1 Year Yearly cash flow cumulative net cash flow £ £ 0 (30,000) (30,000) • 1 9,000 (21,000 • 2 9,000 (12,000) • 3 9,000 (3,000) • 4 9,000 6,000 • 5 9,000 15,000 Therefore 3years = 27,000 then 3000/9000 x 12 = 4 Payback period = 3 years 4months

10. Example 2.2

11. Example 2.2 solution • Undiscounted pay back For A = 4 years For B = 5 years

12. Example 2.2 solution

13. Example 2.2 solution For A, payback is outside the project’s life For B payback is 6.25 yeas (how?)

14. Advantages and disadvantages of payback Read on page 13

15. Accounting Rate of Return (ARR)

16. Lecture Example 2.3

17. Example 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%

18. ARR Read on: Advantages and disadvantages (page 14)

19. Appraisal Methods • 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.

20. NPV

21. Definitions • 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

22. Quick exercise

23. Example 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 • Net present value method. • Internal rate of return

24. Example 2.4: solution

25. Net Present Value 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

26. Net Present Value Solution 2.5 • Year Cash Flow PV factor 13% Present value • 0 (180,000) 1.00 (180,000) • 1 50,000 0.885 44,250 • 2 50,000 0.783 39,150 • 3 50,000 0.693 34,650 • 4 50,000 0.613 30,650 • 5 50,000 0.543 27,150 • 6 50,000 0.480 24,000 • NPV 19,850 • Positive NPV indicates viability of the project. • Negative NPV indicates non-viability of the project.

27. Alternative solution to 2.5 Use the annuity table Year Cash flow DF @13% PV 0 (180,000) 1 (180,000) 1-6 50,000 3.998 199,900 NPV 19,900

28. Appraisal Methods • Internal Rate of Return - is the discount rate that equates the present values of an investment’s cash inflows and outflows. • Internal Rate of Return (IRR) - is the discount rate that causes an investment’s NPV to be zero

29. IRR

30. Example 2.6 Using Lecture example 2.4 (above), calculate the internal rate of return for the project.

31. Internal Rate of Return Solution to 2.6 • IRR Try 15% • Year Cash flow Discount Factor (15%) PV • 0 (2200) 1.000 (2200) • 1 770 0.8696 669.59 • 2 968 0.7561 731.90 • 3 1331 0.6575 875.13 • NPV 76.62

32. Internal Rate of Return • Year Cash flow DC (16%) PV • 0 (2200) 1.000 (2200) • 1 770 0.8621 663.83 • 2 968 0.7432 719.42 • 3 1331 0.6407 852.77 • NPV 36.01

33. IRR • Year Cash flow DCF (17%) PV • 0 (2200) 1.000 (2200) • 1 770 0.8475 652.58 • 2 968 0.7305 711.48 • 3 1331 0.6244 831.08 • NPV (4.86) • Interpolation • 16 + 36.01 / 40.87 = 16.88%

34. Appraisal Methods Please read more on the advantages and disadvantages of these techniques Why is the NPV considered superior over the other methods, even the IRR?

35. End of Lecture 2 Any question please?