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Week3: Investment Appraisal

Week3: Investment Appraisal. 16th October 2007. Investment. Placing a sum of capital, expecting return Investment made now, Returns come in future Returns may be uncertain. Two Categories of Measure. Those accounting for the time value of money And those not

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Week3: Investment Appraisal

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  1. Week3: Investment Appraisal • 16th October 2007

  2. Investment • Placing a sum of capital, expecting return • Investment made now, Returns come in future • Returns may be uncertain

  3. Two Categories of Measure • Those accounting for the time value of money • And those not • Amongst the former: ARR, Payback • And the latter: NPV, Profitability Index, IRR

  4. Non Time Value of Money based • ARR and Payback • I place an investment, how much to I get back? • Quick and simple measures, • There is some evidence that payback is widely used, though NPV is a more “rational” measure

  5. ACCOUNTING RATE OF RETURN (ARR) A form of Return on Investment (ROI) ARR = Estimated Average Profit x 100% Estimated Average Investment Profit is Accounting Figure based on accruals Accounting Principles - After depreciation and before Taxation If ARR is greater than target rate, project is accepted Does not take account of Time Value of Money

  6. PAYBACK PERIOD Project A Project B Initial Investment - 10,000 - 10,000 Cash Inflow Year 1 + 4,000 + 2,000 Year 2+ 6,000 + 5,000 Year 3 + 4,000 + 6,000 Year 4 + 2,000 + 6,000 Year 5 + 2,000 + 4,000 What is current value of Cash Flow in later periods

  7. The Future is............

  8. Relevant (you are interested in the value of streams of future cash flow) • Uncertain: “A bird in the hand is worth two in the bush”

  9. TIME VALUE OF MONEY Compound Interest S = P (1 + i)n n = Time period - years i = Interest rate P = Initial sum of money S = Future Sum

  10. DISCOUNTED CASH FLOW P = S (1 + i)n Where discount factor = 1 see tables (1 + i)n For i = 12% Cash Flow Discount Factor Present Value Initial Investment - 2,000 1.0 -2,000.0 Cash Flow Year 1 + 600 0.893 535.8 Year 2 + 600 0.797 478.2 Year 3 + 600 0.712 427.2 Year 4 + 600 0.636 381.6 Year 5 + 600 0.567340.2 NET PRESENT VALUE 163.0 To compare projects calculate NPV and Select one with higher NPV

  11. NPV How to pt 1 • Typically you will be given an investment, a discount rate (and set of discount factors) and a set of profits. • You will then have to do a couple of things:

  12. Transform Profits into Cashflow • DO this by adding back depreciation: • An investment of 100K is made, the life of the investment is 4 years. • Depreciation (by straight line method) will be 100/4 = £25K per year. • Add this to profits to get annual cash flows.

  13. 2: Discount the Cash Flows • Multiply the cash flow by the discount factors: These will be given for the chosen discount rate.

  14. Year D.f. 1 0.91 2 0.83 3 0.75 4 0.68 Example: Discount factors for a rate of 10%

  15. Profit Depr. CF df PV 10 25 35 0.91 31.85 15 25 40 0.83 33.2 15 25 40 0.75 30 10 25 35 0.68 23.8 Multiply CF by d.f.

  16. Sum PVs and subtract initial investment • Sum (PVs) = 118.85 • Initial Investment = 100 (discount factor =1 because it happens in year 0) • NPV= 118.85-100 = 18.85 • Is the NPV > 0? If it is you can go ahead with the investment. • Is the desired return high enough? If NPV is higher than trigger value, go ahead.

  17. INTERNAL RATE OF RETURN NPV + 0 - IRR IRR Discount Rate Project P Internal Rate of Return = Discount Rate at which NPV = 0 Project Q

  18. SHORTCOMINGS : • Can be multiple solutions to IRR • Can be conflict with NPV e.g. in previous graph for low discount rate Q better, for high discount rate P better

  19. Profitability Index Profitability Index = NPV Initial Investmente.g. Project 1 Project 2NPV £1M £2MInitial Investment £10M £40MProfitability Index 10% 5%

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