CAP1 Finance Session 2 Slides
-
Upload
kimringine -
Category
Documents
-
view
225 -
download
0
Transcript of CAP1 Finance Session 2 Slides
-
8/10/2019 CAP1 Finance Session 2 Slides
1/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland
Session 2
Capital Investment Appraisal(An Introduction)
-
8/10/2019 CAP1 Finance Session 2 Slides
2/41
-
8/10/2019 CAP1 Finance Session 2 Slides
3/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland
Ethics & Professionalism
Objectivity
Perceptiveness of own knowledge,values and limitations
Strategic Thinking & Problem Solving
Communication
Managing Self & Others:Leadership
IT Awareness
Project Management &Change Awareness
Stakeholder Management
Financial Reporting
Management Accounting & Finance
Audit & Assurance
Tax & Law
Strategy
Competency Wheel
-
8/10/2019 CAP1 Finance Session 2 Slides
4/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland
Mapping
This lecture maps specifically to 2.1 on the Competency Statement
FunctionalCompetencies
BusinessCompetencies
Core ProfessionalValues & Skills
Explain and demonstrate
the ability to use thepayback, discountedpayback, accounting rate ofreturn, net present valueand internal rate of returntechniques.
Be able to appraise a
variety of different projectsfor communication tomanagement.
The need to be objective
when evaluating differingprojects.
Recommend and justify acourse of action, includingconsideration of non-financial factors.
Evaluate and communicatean appropriate course ofaction given the entitysunique characteristics andthe environment
-
8/10/2019 CAP1 Finance Session 2 Slides
5/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 5
Difficulties with Project Appraisal
-
8/10/2019 CAP1 Finance Session 2 Slides
6/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 6
Difficulties facing project appraisal
Goal congruence Relevant cash flows Time value of money Profit versus cash Capital rationing
Projects with unequal lives Risk (next class) Financing
-
8/10/2019 CAP1 Finance Session 2 Slides
7/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 7
Goal Congruence
Ultimately the projects outcome should increase equity holder value.
Decision makers - view the big picture, which may involve rejectingprojects that have short-term returns in favour of projects with higheroverall long-term returns.
Take liquidity into consideration.
-
8/10/2019 CAP1 Finance Session 2 Slides
8/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 8
Relevant cash flows
Not all cash flows should be brought into the appraisal process only relevant cash flows.
Relevant cash flows are incremental cash flows and opportunity
cash flows.
They exclude: Sunk costs Apportioned costs that were going to be incurred anyway
-
8/10/2019 CAP1 Finance Session 2 Slides
9/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 9
Cash flows explained
Incremental cash flows are those that will occur only as aconsequence of a project being undertaken.
Opportunity cash flows are cash flows forgone from other
investments, or actions that have been changed, as a result ofthe project being implemented.
Cash flows that occur as a result of decisions made in the past,
which cannot be changed are deemed to be sunk cash flows.
-
8/10/2019 CAP1 Finance Session 2 Slides
10/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 10
The time value of money/cash V profit
In finance CASH IS KING.Cash is very different to profit.Management performance is usually assessed using profitability.However, the pattern of cash is more important for project appraisal
because of the time value of money.
Example (assume you are assessing a 5 year period) in terms ofprofitability /1m each year for 5 years is the same as /5 millionat the end of year 5.
In finance, the latter option is valued much LOWER because of thetime value of money
-
8/10/2019 CAP1 Finance Session 2 Slides
11/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland
Financing
BRIEF POINTS Matching principle match the life of the project with the
life of the finance Self-liquidating try to ensure that the finance selected
has liquidity commitments that can be serviced from theproject itself Cash synchronisation match the timing of the cash flows
resulting from the investment with the timing of therepayments on the source of finance.
Cost of finance take into account the companys currentcost of capital
Note: This to pic i s c overed in de ta il later in the co urs e
-
8/10/2019 CAP1 Finance Session 2 Slides
12/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 12
Project appraisal - techniques
Accounting Rate of Return (ARR)Payback periodDiscounted payback periodInternal rate of return (IRR)Net present value (NPV)
-
8/10/2019 CAP1 Finance Session 2 Slides
13/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 13
Accounting Rate of Return
-
8/10/2019 CAP1 Finance Session 2 Slides
14/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 14
ARR
The accounting rate of return estimates the rate of accountingprofit that a project will generate over its entire life.
It compares the average annual profit of a project with the
average cost (book value) of the project.
-
8/10/2019 CAP1 Finance Session 2 Slides
15/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 15
ARR - calculation
ARR = Average annual profit x 100 Average capital invested
Where the average annual profit is the total profit for thewhole period (after depreciation) divided by the life of theinvestment in years; and
The average capital invested is the initial capital cost plus theexpected disposal value divided by two.
-
8/10/2019 CAP1 Finance Session 2 Slides
16/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 16
ARR example
Cow Ltd. is considering three projects (each costing /240,000).The following cashflows are predicted:Friesian Aberdeen Saler
Cashflows / / /Year 1 160,000 120,000 238,000Year 2 60,000 120,000 2,000Year 3 120,000 40,000 35,000Year 4 140,000Year 5 20,000Year 6 10,000
REQUIREDGiven that Cow Ltd. has a target average accounting rate of return of 10% per
annum which of the above projects should be accepted, if any? (Assume that theasset is specialised and cannot be sold at the end of the project).How would the results be affected were you informed that the asset could be soldafter three years for /60,000 and after six years for /30,000.
-
8/10/2019 CAP1 Finance Session 2 Slides
17/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 17
ARR - advantages
Advantages include: As it is based on profits management understand it better. Profits are important, a project should not only have positive cash flows but
should also be profitable. It is a useful target for screening projects
-
8/10/2019 CAP1 Finance Session 2 Slides
18/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 18
ARR - disadvantages
Disadvantages include: It ignores cash flows It ignores the time value of money. It ignores the size of a project (risk) It ignores the duration of a project (risk)
A project that has a longer life but is overall more profitable and has morecash inflows will be penalised because of its long life.
Subjective (hurdle rate)
-
8/10/2019 CAP1 Finance Session 2 Slides
19/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 19
Payback period
-
8/10/2019 CAP1 Finance Session 2 Slides
20/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 20
Payback period
The payback period method ranks investments in order of thespeed at which the initial cash outflow is paid back bysubsequent cash inflows.
This method focuses on cash flows not profits, thereforedepreciation and accrual accounting is ignored.
This method calculates the number of years it takes forcumulative cash flows to achieve breakeven point.
-
8/10/2019 CAP1 Finance Session 2 Slides
21/41
-
8/10/2019 CAP1 Finance Session 2 Slides
22/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 22
Payback method - advantages
Advantages include: Simple and quick to calculate. Readily understandable. Useful risk screening technique Focuses management attention on projects with more reliable estimates.
Useful for companies with liquidity issues Helps decide between two projects with similar ARRs.
-
8/10/2019 CAP1 Finance Session 2 Slides
23/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 23
Payback method - disadvantages
Disadvantages include: It ignores the time value of money. It ignores the profitability of a project (risk) It ignores cash flows received after the payback period It ignores the size of a project (risk)
It ignores the impact of a project (strategic)
-
8/10/2019 CAP1 Finance Session 2 Slides
24/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 24
Discounted Payback Period
-
8/10/2019 CAP1 Finance Session 2 Slides
25/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 25
Discounted payback period
The discounted payback period method overcomes one of the weaknesses of thepayback period method, as it takes the timevalue of money into consideration.
This method ranks investments according to thespeed at which the cumulative discountedcash flows (DCF) of an investment cover theinitial cash outlay.
-
8/10/2019 CAP1 Finance Session 2 Slides
26/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 26
Discounted payback method - example
Cow Ltd. is considering three projects (each costing /240,000).The following cash flows are predicted:Yearly profits Friesian Aberdeen SalerBefore depreciation / / /Year 1 160,000 120,000 238,000Year 2 60,000 120,000 1,000
Year 3 120,000 40,000 36,000Year 4 140,000Year 5 20,000Year 6 10,000
REQUIRED
Which of the above projects should Cow Ltd. invest in. Cow Ltd. has toborrow funds at 10%. Management decide that this is an appropriatediscount rate to use and it is company policy to use the discounted paybackperiod method for capital investment appraisal.
-
8/10/2019 CAP1 Finance Session 2 Slides
27/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 27
Discounted payback method - advantages
Advantages include: Simple and quick to calculate. Readily understandable. Useful risk screening technique Focuses management attention on projects with more reliable estimates.
Useful for companies with liquidity issues Helps decide between two projects with similar ARRs Takes the time value of money into consideration.
-
8/10/2019 CAP1 Finance Session 2 Slides
28/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 28
Discounted payback method - disadvantages
Disadvantages include: It ignores the profitability of a project (risk) It ignores cash flows received after the
payback period It ignores the size of a project (risk) It ignores the impact of a project (strategic)
-
8/10/2019 CAP1 Finance Session 2 Slides
29/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 29
Net Present Value (NPV)
-
8/10/2019 CAP1 Finance Session 2 Slides
30/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 30
Net Present Value (NPV)
The NPV method of project appraisal, discounts the cashinflows and outflows of an investment, to their presentvalue.
Use of the correct discount rate is very important.
If the NPV is positive then a project should be accepted; asthe positive amount will increase equity holder value.
If the NPV is negative then a project should be rejected asacceptance will damage equity holder value.
-
8/10/2019 CAP1 Finance Session 2 Slides
31/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 31
NPV method example
Cow Ltd. is considering three projects (each costing /240,000).The following cash flows are predicted:Yearly profits Friesian Aberdeen SalerBefore depreciation / / /Year 1 60,000 120,000 238,000Year 2 60,000 120,000 1,000
Year 3 100,000 40,000 36,000Year 4 130,000 3,000Year 5 20,000Year 6 10,000
REQUIREDCalculate each project's NPV and rank the resulting information forreporting to management. The company has a WACC of 16% and allthe projects being considered are of similar risk to the current operatingactivities of the company.
-
8/10/2019 CAP1 Finance Session 2 Slides
32/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 32
NPV method - advantages
Advantages include: The time value of money is taken into consideration. All relevant cash flows are considered in the appraisal process. The discount rate can be adjusted for risk. When there are several alternatives the alternative with the largest NPV will
maximise equity holder value. Unlike the IRR, when cash flows are not conventional, the NPV will provide
one answer.
-
8/10/2019 CAP1 Finance Session 2 Slides
33/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 33
NPV method - disadvantages
Disadvantages include: Time consuming calculations (though can be
compiled by a computer).
It does not provide a method of decidingwhich investment provides the best value formoney.
It considers the absolute amount of moneyavailable over a projects life.
It does not consider scale, hence risk.
-
8/10/2019 CAP1 Finance Session 2 Slides
34/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 34
Internal Ratio of Return (IRR)
.
-
8/10/2019 CAP1 Finance Session 2 Slides
35/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 35
Internal Rate of Return (IRR)
The IRR , sometimes referred to as the discounted cash flow yieldmethod also involves discounting future cash flows to theirpresent value.
It could be considered a type of break-even analysis, which focuses
on trying to find the discount rate at which the present value ofthe discounted future cash flows (inflows and outflows combined)equals the initial investment cash outlay.
This discount rate is then compared to a hurdle rate to determine ifthe project should be accepted or not.
-
8/10/2019 CAP1 Finance Session 2 Slides
36/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 36
Calculating the IRR
Step 1: Select two discount rates at random
Step 2: Discount the cash flows at the discount rates to findthe net present value
Step 3: Use interpolation to find the rate at which the NPV ofthe cash flows is zero.
IRR = Rate 1 + NPV 1 (Rate 2 Rate 1)NPV 1 - NPV 2
-
8/10/2019 CAP1 Finance Session 2 Slides
37/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 37
IRR method example
Cow Ltd. is considering a project (costing /240,000).The following cash flows are predicted:Yearly profits FriesianBefore depreciation /Year 1 160,000Year 2 60,000Year 3 120,000Year 4 40,000Year 5 30,000
REQUIREDCalculate the IRR of the above named project using interpolation .
-
8/10/2019 CAP1 Finance Session 2 Slides
38/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 38
IRR method - advantages
Advantages include: The time value of money is taken into consideration. All cash flows are considered in the appraisal process.
-
8/10/2019 CAP1 Finance Session 2 Slides
39/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 39
IRR method - disadvantages
Disadvantages include: Time consuming calculations (though can be compiled by a computer). The linearity assumption that underlies the interpolation process. It ignores the scale of projects. It is difficult to utilise when investments have unconventional cash flows, as more
than one IRR will result.
-
8/10/2019 CAP1 Finance Session 2 Slides
40/41
CAP1 Finance, Academic Year 2011 / 2012 Chartered Accountants Ireland 40
Research findings
The payback method is the most commonly used method usedas screening device the remaining projects are usuallyassessed using either the ARR or the IRR.
Most companies set a subjective IRR/ARR hurdle rate andaccept projects with a higher return.
Academics consider the NPV to be the most appropriate methodRecent research has shown that use of DCF techniques is
increasing particularly in large entities with a preference for theuse of the NPV or a combination of the NPV and the IRR
-
8/10/2019 CAP1 Finance Session 2 Slides
41/41
Summary
There are many factors which have to be consideredbefore undertaking investment appraisal Identifying relevant cash flows The timing of cash flows The strategic fit of the project The impact on other areas The correct appraisal approach Financing
Several methods ARR Payback Discounted payback Net present value IRR
In most instances all are used with qualitative informationto inform the decision.