Capital Investment1

7/28/2019 Capital Investment1

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INVESTMENT EVALUATION.

In its simplest form, an investment decision can be defined as one which

involves the firm in making a cash outlay with the aim of receiving, in

return, future cash inflows greater than the initial cash outflow.

It follows that an investment decision has a large implication for a firms

cash flows initially with the outflow of cash upon the purchase of the

asset and thereafter with the future inflows of cash as a result of the asset

ownership.

Therefore, the starting point of any investment evaluation must be with

the construction of the CASH-FLOW FORECAST, ie;- identification of

the quantities and timings of all the cash flows into and out of the firm.

(NOTE;- for the purposes of cash-flow forecasting, money not flowing

out of the company due to the ownership of an asset is perceived as

money flowing into the company, ie;- a saving in salaries is money not

flowing out of the company, this is therefore perceived as a positive in-

flow of money to the company as far as investment evaluation is

concerned.)


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EXAMPLE:- Your company, a medium size manufacturing company,

manufactures a range of engine management systems for sale as original

equipment to the automotive manufacturing market. This market is

expected to grow at 10% per year for the next 5 years. The current

production line is just about at capacity, although you are currentlyworking a two shift system to maintain current production levels. An

alternative to recruiting additional labour is to invest in CNC machines,

which will increase the capacity of your production to absorb the

expected growth in demand for at least the next five years on a single

shift basis.

The purchase of 3 new CNC machines will form the basis of a flexible

manufacturing cell. The CNC machines will cost 250,000 each, and are

expected to last for 5 years, after which they will be sold off for 25,000each. The additional dedicated tooling for your current production range

will cost a further 80,000 in total and a further 25,000 will be required

for material handling equipment, etc. The maintenance of the tooling and

associated equipment will be done in-house at an estimated cost of

5,000 per year, but because your maintenance department does not have

the experience/expertise to maintain the CNC machines, a contract will

be taken out at a cost of 10,000 per year. It is further estimated that a

saving of 5,000 per year in reduced scrap/rework should be realised, and

the existing 8 old capstan lathes can be sold off for 2,500 each.

The new cell will be operated by 3 programmer/operators recruited out of

the existing workforce of 16 machinists, who are currently paid 20,000

each inclusive of shift premium etc. Following training, at a cost of

10,000, (to be paid within the first 3 months), they will be paid a salary

of 22,000 per year each. The remaining 13 machinists can be

considered as a saving, together with a maintenance fitter who currently

earns 18,000 per year. Your companys current cost of capital is 10%.


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Using the above information it is necessary to construct a CASH-FLOW

FORECAST showing the timings and quantities of all the expected cash

flows;-

0 1 2 3 4 5

BENEFITS;-

machinists, 13@20k. - 260 260 260 260 260

maintenance fitter@18k - 18 18 18 18 18

scrap/rework - 5 5 5 5 5

cnc m/c scrap value 3@25k - - - - - 75

capstan scrap value [email protected] 20 - - - - -

TOTAL BENEFITS;- 20 283 283 283 283 358

COSTS;-

cnc m/c. 3@250k 750 - - - - -

tooling. 80 - - - - -

matl. handling equip. 25 - - - - -

cnc m/c maintenance - 10 10 10 10 10

tooling maintenance. - 5 5 5 5 5

prog/ops. 3@2k - 6 6 6 6 6

training - 10

TOTAL COSTS;- 855 31 21 21 21 21

NET CASH FLOW:- (835) 252 262 262 262 337
mailto:fitter@18kmailto:fitter@18k


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PAYBACK METHOD.

This is one of the most tried and trusted of all investment appraisal

methods and its name neatly describes its operation, referring to how

quickly the incremental benefits that accrue to a company from aninvestment project PAYBACK the initial capital invested.

EXAMPLE;-

Year cash-flow cumulative cash-flow.

0 (835) (835)

1 252 (583)

2 262 (321)

3 262 (59)

3+262

59years.

(3.225yrs)

4 262 203

5 337 540

PAYBACK = 3.225 years.

Advantages;-

- quick to use and easy to understand

- good for capital rationing- minimises the risks of error (uncertainty) in long-term forecasting.

Disadvantages;-

- doesnt take account of the life of the project

- doesnt take account of the time value of money.


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RETURN ON INVESTMENT METHOD.

In its simplest form it is the average annual return expressed as a

percentage of the initial capital employed. (Note;- a variation on thistechnique is called Accounting Rate of Return however this

technique, as the name suggests, is based on PROFIT and therefore is not

a cash flow technique in itself).

Return on Investment = employedcapitaltotalreceiptsannualaverage

1

100

Example;-

Return on Investment =855

5/)33726226226225220( +++++

1

100

ROI =1

100

855

5/)1395( =

1

100

855

279 =

32.63%

ROI = 32.63%

Advantages;-

- quick to use and understand

- expressing a return as a percentage is easily understood

- easy to compare with alternatives

- directors performance is judged by shareholders return on

investment

- takes account of the life of the project.

Disadvantages;-

- a percentage return does not take into account the actual cash-flow

benefits to a companys liquidity.

- Doesnt take into account the time value of money.


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TIME VALUE OF MONEY.

The value of money alters with time;-

1.00 invested today @ 10% interest will increase in value with time, ie;-

Time Period- 0 1 2 3 4 5

Value- 1.00 1.10 1.21 1.331 1.4641 1.61051

Therefore when making an investment decision the s spent today are

not the same value as the future s. It is therefore necessary to

DISCOUNT all the future s to the same value as the s that arebeing spent today. This is achieved by dividing the actual future cash

flows by the compound interest rate (or multiplying by Its reciprocal);-

Actual cash flow- 000s 000s 000s 000s 000s 000s

Divide* by- 1 1.10 1.21 1.33 1.46 1.61

(Alternatively** by) (1) (.9091) (.8264) (.7513) (.6830) (.6209)

(*Amount of 1 at compound interest: (1+r)n

**Present value of 1 at compound interest: (1+r)-n ie discount factors).

This will DISCOUNT all the future cash flows to todays value, ie;- the

value of all the future actual cash flows has been discounted back to the

same value as the s being spent today. Techniques which make use of

this process are called DISCOUNTED CASH FLOW TECHNIQUES.


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NET PRESENT VALUE METHOD.

This technique calculates the difference between the cost of the

investment and the PRESENT VALUE of all the future actual cash flows.

An acceptable NET PRESENT VALUE would have a positive value, ie;-the sum of all the future actual cash flows discounted to todays value is

greater than the initial expenditure.

EXAMPLE;-

10%

Year cash flow discount factor = present value.

0 (835) 1.0000 (835.0000)1 252 0.9091 229.0932

2 262 0.8264 216.5168

3 262 0.7513 196.8406

4 262 0.6830 178.9460

5 337 0.6209 209.2433

NPV = 195.6399

NET PRESENT VALUE = 195,640

Advantages;-


- takes account of the time value of money

- takes into account the life of the project.

Disadvantages;-

- an arbitrary technique, ie- if NPV>1 accept investment proposal

- doesnt acknowledge the risks of error (uncertainty) in long term

forecasting.


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DISCOUNTED PAYBACK METHOD.

This is a modified version of the payback method. The technique is the

same except that the cast flows arent actual cash flows but theDISCOUNTED CASH FLOWS.

EXAMPLE;-

10%


0 (835) 1.0000 (835.0000)

1 252 0.9091 229.09322 262 0.8264 216.5168

3 262 0.7513 196.8406

4 262 0.6830 178.9460

4+2433.209

6034.13

yrs.

5 337 0.6209 209.2433 = 4.0650yrs.

DISCOUNTED PAYBACK = 4.065 years.

Advantages;-


- good for capital rationing

- minimises the risks of error (uncertainty) in long-term forecasting.

Disadvantages;-

- doesnt take account of the life of the project.


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INTERNAL RATE OF RETURN METHOD.

This technique calculates the interest rate that would be necessary to give

a Net Present Value equal to ZERO.

At low interest rates the NPV of an investment will be relatively high,however, as the interest rate increases, the NPV will decrease, until

eventually it will become a negative value. Therefore to calculate the

point at which the interest rate will give a zero NPV, it is necessary to

have a positive NPV and a negative NPV and then interpolate between

these two values to find the interest rate which will gives a ZERO NPV.

EXAMPLE;-

10%


0 (835) 1.0000 (835.0000)

1 252 0.9091 229.0932

2 262 0.8264 216.5168

3 262 0.7513 196.8406

4 262 0.6830 178.9460

5 337 0.6209 209.2433

NPV = 195.6399

20%


0 (835) 1.0000 (835.0000)

1 252 0.8333 209.9916

2 262 0.6944 181.9328

3 262 0.5787 151.6194

4 262 0.4823 126.3626

5 337 0.4019 135.4403

NPV = (29.6533)

IRR;- 10% +( )

6533.296399.1956399.195

(20%-10%)

IRR = 10% +

%10

2932.225

6399.195% + 8.68379%)

= (10

IRR = 18.68%


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Therefore, the Internal Rate of Return is approximately equal to 18.68%,

however, because a linear interpolation across a curve will give an error,

it is possible to get a more accurate figure;-

18%Year cash flow discount factor = present value.

0 (835) 1.0000 (835.0000)

1 252 0.8475 213.5700

2 262 0.7182 188.1684

3 262 0.6086 159.4532

4 262 0.5158 135.1396

5 337 0.4371 147.3027

NPV = 8.6339

( The NPV is positive, therefore the IRR must be above 18%)

19%


0 (835) 1.0000 (835.0000)

1 252 0.8403 211.7556

2 262 0.7062 185.0244

3 262 0.5934 155.4708

4 262 0.4987 130.6594

5 337 0.4190 141.2030

NPV = (10.8868)

Therefore;- NPV = 8.6339 @ 18%

NPV = (10.8868) @ 19%

IRR;- 18% + ( )

8868.106339.86339.8

(19%-18%)

IRR = 18% +

%1

5207.19

6339.8= (18% + 0.4423%) = 18.44%

IRR =18.44%


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Therefore if the company had to pay 18.44% for its capital, (the interest

rate the company pays to borrow the funds, or the interest rate the

company foregoes by not investing the funds in interest bearing

investments), the NPV would be zero ie;- no gain/(loss).

Advantages;-

- takes into account the life of the project

- takes into account the time value of money

- focuses on one of the critical success factors (the interest rate )

which maybe beyond the companys control.

Disadvantages;-- it only considers one of the critical success factors others

could be equally or more important.

+ve

NPV

Linear Interpolation.

195.640

IRR 18.68%

0 20%

10% Interest

(29,653)

Rate.

-veNPV IRR = 18.44%

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