Managing Finance and Budgets

1. Managing Finance and Budgets Seminar 7

2. Follow-up Activities • Read Chapter 14 (including EPNV) • Describe key concepts: Purpose of Investment Appraisal Accounting Rate of Return Payback Period Discounted Cash Flow Internal Rate of Return Cost-benefit analysis • Exercises 14.1 and 14.2

3. Questions 1 • What precisely is meant by ‘Investment’? • Give the full names of the following tools for analysing the value of an investment, • ARR • PP • NPV • IRR

4. Four methods of evaluation: Accounting rate of return (ARR) Payback period (PP) Net present value (NPV) Internal rate of return (IRR) Methods of investment appraisal

5. Questions 2 • Explain the difference between ARR and PP, • Explain why ARR is thought to be the more useful measure.

6. ARR = Average annual profit________ x 100%Average investment to earn that profit Accounting rate of return (ARR)

7. The payback period is the length of time it takes for the initial investment to be repaid out of the net cash inflows from the project. Payback period (PP) Payback period (PP)

8. Project 1 Payback period Yr 1 Yr 2 Yr 4 Yr 5 Yr 3 Yr 1 Yr 2 Yr 4 Yr 5 Yr 3 Yr 1 Yr 2 Yr 3 Yr 4 400 600 300 500 700 800 900 0 100 200 Yr 1 Yr 5 Cash flows (£000) Project 2 Project 3 The cumulative cash flows of project with different types of yield

9. Questions 3 • Explain why the value of £1000 invested and returned in five year’s time may not be equal to its present value. • State three factors which need to be taken into account in calculating the discount rate used to determine the Net Present Value. • Carry out the calculations to work out the net present value of £1 in 1 year, 2 years, 3 years, 4 years and 5 years time. • M & A Exercise 14.1

10. Discount rate Interest foregone Inflation Risk premium The factors influencing the discount rate to be applied to a project

11. Year Present value of £1 1 2 3 4 5 1.000 (1 + 0.2)0 0.833 (1 + 0.2)1 0.694 (1 + 0.2)2 0.579 (1 + 0.2)3 0.482 (1 + 0.2)4 0.402 (1 + 0.2)5 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

12. Questions 4 • Why is NPV superior to ARR and PP? • What factors affect the sensitivity of NPV calculations?

13. It addresses the following issues: The timing of the cash flows The whole of the relevant cash flows The objectives of the business Why NPV is superior to ARR and PP

14. Project life Annual sales volume Sales price Project NPV Operating costs Initial outlay Financing cost Factors affecting the sensitivity of NPV calculations

15. Questions 5 • Explain what is meant by IRR. • Explain the relationship between IRR and NPV. • M & A 14.2

16. The internal rate of return is the discount rate, which, when applied to the future cash flows of a project, will produce an NPV of precisely zero. Internal rate of return (IRR) Internal rate of return (IRR)

17. 70 NPV (£000) 60 IRR 50 40 30 20 10 0 20 30 10 40 Rate of return (%) The relationship between the NPV and IRR methods

18. £18,660 (positive) 6% D NPV(£000) 15% + 0 G H Discount rate (%) - E NPV £23,490 (negative) F Finding the IRR of an investment by plotting the NPV against the discount rate

19. Questions 5 • In addition to the IRR, PP, NPV and IRR analysis what other issues might affect a company’s decision to invest ? • What is the relationship between risk and expected return?

20. Some practical points Relevant costs Opportunity costs Taxation Cash flows and profit flows Dealing with questions relating to investment appraisal

21. Return(%) Riskpremium Risk-free rate Risk Relationship between risk and return

22. Questions 6 • Describe the stages that you would expect to go through in managing an investment project.

23. Determine investment funds available Stage 1 Identify profitable project opportunities Stage 2 Evaluate the proposed project Stage 3 Stage 4 Approve the project Monitor and control the project Stage 5 Managing the investment decision