Investment Appraisal

1. 2BUS0197 – Financial Management Investment Appraisal

2. Learning outcomes By the end of this session students should appreciate: The main investment appraisal methods The reasons why discounted cash flow methods are preferred Why net present value is regarded as superior to internal rate of return Capital rationing and investment appraisal The role of taxation, inflation, risk and uncertainty on investment decisions The application of sensitivity analysis to investment projects

3. The net present value method Uses discounted cash flows to evaluate capital investment projects A cost of capital or target rate of return is used to discount all cash inflows to their present values The present value of all cash inflows is then compared to the present value of all cash outflows A positive net present value indicates that an investment project is expected to give a return in excess of the cost of capital and will therefore increase shareholder wealth

4. The net present value method where: I0 is the initial investment C1, C2, …, Cnare the project cash flows occurring in years 1, 2, …, n r is the cost of capital or required rate of return N.B. Cash flows occurring during a time period are assumed to occur at the end of that period Decision rule: accept all independent projects with a positive net present value With mutually exclusive projects, select project with highest NPV

5. Example • A project costing £1,000 is expected to yield £500 per year for 2 years. Calculate its NPV Year Cash flow 10% PVF PV 0 (1,000) 1.000 (1,000) 1 500 0.909 455 2 500 0.826 413 NPV = (132) Question: Would you accept the project?

6. Pros and cons of NPV method • Advantages: • Accounts for the time value of money • Uses cash flows, not accounting profit • Takes into account timing and amount of project cash flows • Takes account of all relevant cash flows over the life of a project • Disadvantages: • Accepting all projects with positive NPV only possible in a perfect capital market • Cost of capital may be difficult to find • Cost of capital may change over project life, rather than being constant

7. The internal rate of return (IRR) method IRR of an investment project is the cost of capital or required rate of return which, when used to discount the cash flows from a project, produces a net present value of zero where: I0 is the initial investment C1, C2, …, Cnare the project cash flows occurring in years 1, 2, …, n r* is the internal rate of return

8. The internal rate of return (IRR) method The IRR method involves calculating the IRR of a project by linear interpolation and then comparing it with a target rate of return (or hurdle rate) Decision rule: accept all independent investment projects with an IRR greater than the company’s cost of capital or target rate of return

9. Internal rate of return NPV £9,500 0 10% 18% IRR Discount rate £3,000 Investment project _

10. Estimating the IRR of a project In the previous example, the NPV for r = 18% is negative, while the NPV for r = 10% is positive Hence, the IRR giving a zero NPV falls between 10 and 18%. Using linear interpolation it is possible to estimate the IRR by applying the following formula:

11. Comparing NPV and IRR methods + Area of conflict NPV 0 Discount rate IRR of incremental project Cost of capital _ Project B Mutually exclusive projects: If IRR is used, the wrong project may be selected. NPV always gives the correct selection advice Project A

12. Comparing NPV and IRR methods The basic cash flow profiles Non-conventional cash flows: If an investment project has cash flows of different signs in successive periods (i.e. non-conventional cash flows), it may have more than one IRR Applying the IRR method to projects with non-conventional may result in incorrect decisions being taken The NPV method can accommodate non-conventional cash flow, hence it gives the correct selection advice

13. IRR and NPV with non-conventional cash flows + NPV • Cost of capital = RA • Project accepted by IRR method since IRR1> RA and IRR2> RA • Project rejected by NPV method because NPV<0 for RA • Cost of capital = RB • NPV>0, so accept project • IRR does not offer clear advice since • IRR1 < RB < IRR2 RA RB Discount rate IRR1 IRR2 _

14. Comparing NPV and IRR methods Changes in the discount rate: NPV can accommodate changes in the discount rate over the life of an investment project, while IRR ignores them Reinvestment assumptions: NPV method assumes that cash flows from project can be reinvested at a rate equal to the cost of capital. IRR method assumes that cash flows can be reinvested at a rate equal to IRR. NPV reinvestment assumption is realistic

15. The payback method The payback period is the number of years it is expected to take to recover the original investment from the net cash flows resulting from a capital investment project Decision rule:accept a project if its payback period is equal or less than a predetermined target value

16. Example: a simple investment project The above cash flows refer to an investment project that requires a cash investment at the start of the project, followed by a series of cash inflows over the life of the project (conventional project) Question: What is the payback period for the above project?

17. Pros and cons of payback method • Advantages: • Simple and easy to apply • Should not be open to manipulation as it uses cash flows, not accounting profit • Accounts for risk as it implicitly assumes that a shorter payback period is superior • Disadvantages: • Ignores time value of money • Does not consider the project as a whole since cash flows outside the payback period are taken into account only out of managerial judgement

18. The return on capital employed method • ROCE can be defined as: average annual accounting profit × 100 average investment • Where average investment is: (initial investment + scrap value)/2 • ROCE can also be defined as: average annual accounting profit × 100 initial investment • ROCE is also known as accounting rate of return (ARR) and return on investment (ROI)

19. The return on capital employed method Average annual accounting profit can be calculated from project cash flows by taking off depreciation Accounting profit is not cash flow since depreciation does not correspond to a cash movement Decision rule: accept project if ROCE is equal to or greater than target (or hurdle) rate of return (i.e. current company or division ROCE) If projects are mutually exclusive, the project with the highest ROCE should be selected

20. Example • A machine costs £10,000 and its useful economic life is 5 years. After 5 years, the machine’s scrap value is £2,000. The net cash inflows from the machine would be £3,000 per year. Ignore taxation • Depreciation: (10,000 – 2,000)/5 = £1,600 • Average annual profit: 3,000 – 1,600 = £1,400 • Average investment: (10,000 + 2,000)/2 = £6,000 • ROCE: (1,400/6,000) × 100 = 23%

21. Pros and cons of ROCE method • Advantages: • Measured in %, so comparable with company’s ROCE • Fairly simple to apply • Can be used to compare mutually exclusive projects • Considers all cash flows arising during a project’s life, unlike payback method • Disadvantages: • Uses accounting profit rather than cash • Profit not directly linked to primary financial objective of shareholder wealth maximisation • Uses average profits and hence ignores timing of profits • Ignores time value of money • Relative measure and so ignores size of initial investment

22. Recap on investment appraisal methods NPV is academically preferred as an investment appraisal method – it has no major defects and is consistent with shareholder wealth maximisation IRR comes a close second and can prove to be a useful alternative ROCE and payback methods are flawed as investment appraisal methods but payback is often used as an initial screening method

23. Capital rationing Arises if a firm has insufficient funds to invest in all projects with positive NPV Hard capital rationing:limitations are externally imposed • Capital markets may be depressed • Investors may consider the company to be too risky to invest in • Issue costs may make a small issue of finance expensive Soft capital rationing: limitations are internally imposed. Arises if managers • Want to avoid dilution of control • Want to avoid dilution of EPS • Wish to avoid fixed interest payments (debt) • Wish to follow policy of steady growth • Believe restricting available funds will encourage better investment projects

24. Single period rationing • Firm must choose combination of projects to maximise total NPV • Ranking divisible projects by NPV will not lead to correct decision • Divisible projects must be ranked using the profitability index (PI): PI = PV of future cash flows Initial investment

25. Single period rationing For indivisible projects, selection must be made by looking at total NPVs of possible combinations of projects The combination with highest NPV, which does not exceed capital rationing limit will be optimal investment schedule The investment of surplus funds is not relevant to the investment decision

26. Multi-period period rationing Profitability index and NPV evaluation of project combinations do not help Linear programming must be used to determine the optimum combination Simple problems can be solved by hand, complex problems by computer

27. Relevant project cash flows • Relevant cash flows are incremental cash flows arising from an investment decision, such as initial investment, cash from sales and direct costs • Usually exclude: • Sunk costs – incurred prior to the project start, hence not relevant to project appraisal (e.g. market research) • Apportioned fixed costs – excluded from project evaluation as are incurred regardless of whether a project is undertaken (e.g. rent) • Usually include: • Opportunity costs – if an asset is used for a project, relevant to know what benefit has been foregone • Incremental working capital – increase in working capital will be a cash outflow for the company relevant for the project appraisal

28. Optimising capital investment decisions • The investment appraisal process must account for: • The effects of taxation and inflation on project cash flows • The required rate of return • The risk and uncertainty to which future cash flows are subject

29. Taxation • Tax relief on capital expenditure is given through capital allowances • In the UK: • 25% reducing balance capital allowances given on plant and machinery • 100%, 50% and 40% first-year allowances have been offered for specific investments • In the last year of an investment project a balancing allowance is needed in addition to a capital allowance to ensure that the capital value consumed by the firm over the project’s life has been deducted in full in calculating taxable profits

30. Taxation Tax liability arises on taxable profits Tax relief is available on allowable costs, such as materials, wages and maintenance Interest payments are not relevant cash flows as these are included in the discount rate After-tax cash flows must be discounted with a relevant after-tax cost of capital Timing of tax liabilities and benefits should be considered

31. Inflation Inflation can adversely affect capital investment decisions by reducing the real value of future cash flows and increasing their uncertainty Future cash flows must be adjusted to take into account any expected inflation The real cost of capital is found from the nominal (or money) cost of capital by making an adjustment for inflation: (1 + n) = (1 + r) × (1 + i) hence (1 + r) = (1 + n) (1 + i)

32. Risk and uncertainty Risk refers to a set of unique circumstances, which can be assigned probabilities Uncertainty implies probabilities cannot be assigned to different sets of circumstances In practice, the terms ‘risk’ and ‘uncertainty’ are often used interchangeably The business risk of an investment increases with the variability of returns Uncertainty increases with project life

33. Sensitivity analysis • A method of evaluating project risk by examining how responsive the NPV of a project is to changes in the variables from which it has been calculated • Only one variable is changed at a time (i.e. variables assumed to be independent) • Two methods to measure sensitivity: • Change variables by a set amount then recalculating the NPV • Finding the change in a variable which gives a zero NPV • Both methods give indication of the key variables of an investment project, i.e. small changes in these variables can have a significant adverse effect on the project

34. Problems with sensitivity analysis Only one variable at a time can be changed No indication is given of the probability of changes in key project variables Not really a method of analysing project risk, since probabilities are ignored

35. Summary Today we looked at: • Investment appraisal methods • Comparison between NPV and IRR methods • Relevant project cash flows • Optimisation of capital investment decisions • Taxation • Inflation • Risk and uncertainty • Sensitivity analysis

36. Readings Textbook Watson D. and Head A., (2007), Corporate Finance Principles and Practice, 5th (4th) edition, FT Prentice Hall, Chapters 6 and 7 Research paper Arnold, G. C., Hatzopoulos, P. D. (2000), The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business Finance & Accounting, Vol. 27, 5, pp. 603-626 Barwise, P., Marsh, P. R., Wensley, R. (1989), Must Finance and Strategy Clash?, Harvard Business Review, September- October, pp. 85-90 Phelan, S. E. (1997), Exposing the illusion of confidence in financial analysis, Management Decision, Vol. 35, 2, pp. 163-168

37. Your tutorial activities for next week During the seminar you will beexpected to work on: • Q2 p.187; Q1 p.220(5thed) • Q2 p.179; Q2 p.206 (4thed) To prepare for the seminar you should answer the following practice questions: • EQL - UFM4  • Textbook - Q4 p.183; Q5 p.185; Q3 p218 (5thed) Q4 p.176; Q5 p.178; Q4 p205 (4thed)