Financial Management Investment Appraisal

29
ACCA 2.4 Financial Management & Control Lecture 10 Appraisal of Investments
  • date post

    20-Oct-2014
  • Category

    Documents

  • view

    5.577
  • download

    10

description

ACCA 2.4Investment Appraisels Part 1

Transcript of Financial Management Investment Appraisal

Page 1: Financial  Management    Investment  Appraisal

ACCA 2.4Financial Management & Control

Lecture 10Appraisal of Investments

Page 2: Financial  Management    Investment  Appraisal

What is Finance?

• A discipline mixing Accounting & Economics

• Considers – Theoretical Context & Processes of the

ways the “Economic Entity” raises funds from outside the entity

– The way it should or does apply these funds

– To create “Value” for the providers of funds

Page 3: Financial  Management    Investment  Appraisal

What Managers Should Be Doing• Invest in projects that yield a return greater

than the minimum acceptable rate.– The rate should be higher for riskier projects and

reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

– Returns on projects should be measured based on cash flows generated and the timing of these cash flows

– they should also consider both positive and negative side effects of these projects.

• Choose a financing mix that minimizes the required rate and matches the assets being financed.

Page 4: Financial  Management    Investment  Appraisal

What Managers Should Be Doing

• If there are not enough investments that earn the hurdle rate, return the cash to shareholders.– The form of returns - dividends and share

buybacks - will depend upon the shareholders’ characteristics.

• Objective: – Maximize the Value of the

Firm

Page 5: Financial  Management    Investment  Appraisal

Investment Appraisal

Page 6: Financial  Management    Investment  Appraisal

The Manager’s Duty• Invest in projects that yield a return greater

than the minimum acceptable rate.– Returns on projects should be measured based on

cash flows generated and the timing of these cash flows

– The minimum acceptable rate should be The minimum acceptable rate should be higher for higher for riskier projects riskier projects and reflect the and reflect the financing mix financing mix used - used - owners’ funds (equity) or borrowed money (debt)owners’ funds (equity) or borrowed money (debt)

– they should also consider both they should also consider both positive and positive and negative side effects negative side effects of these projectsof these projects

Page 7: Financial  Management    Investment  Appraisal

Measuring the Project Cash Flow• Cash Flows on Projects Are

– OUT• Purchase of Assets

– Fixed Assets, Working Capital, Intangible Assets, • Operating Costs, Taxes

– IN• Sales of Assets

– Fixed Assets, Working Capital, Intangible Assets• Operating Income

• Note Financing Costs are excluded from this cash flow – this would be double counting

Page 8: Financial  Management    Investment  Appraisal

Question The Frank Assuming Manufacturing Company is considering the purchase of a new machine for £200,000 as detailed below:

The machine is scheduled to last for 6 years and will be depreciated straight line over the period, with a scrap value of £50,000;

Capital allowances are available on this machine at 10% per annum on a straight-line basis, and the effective corporation tax rate is 35%. No further capital allowances are available if the machine is sold. The present 10% rate of capital allowance continues to apply in the year the machine is sold. Note that corporation tax is payable in the current year;

As it is expected to remove a production bottleneck, production will increase from 40,000 units to 50,000 units a year initially, and then to 56,000 units for the last three years;

The additional units will reduce the sales price from £3.60 each to £3.20 each; The machine will generate efficiency cost savings of £22,500 for each of the next 2

years and £30,000 thereafter until year 6; The company's cost of capital is 10%; Round up your figures to the nearest pound.

Further information – Present Values @ 10% Year 1 = 0.9091 Year 4 = 0.6830 Year 2 = 0.8264 Year 5 = 0.6209 Year 3 = 0.7513 Year 6 = 0.5645 a). Calculate the Payback period, Net Present Value, Accounting Rate of Return. Should the machine be bought?

Page 9: Financial  Management    Investment  Appraisal

Measuring the Cash Flow

Page 10: Financial  Management    Investment  Appraisal

The Cash Flow• The cash flow occurs during time periods• The initial outlay occurs in year zero• Depreciation is NOT a cash flow

– It is an accounting convention which attempts to spread the cost of buying an asset over the time periods during which the asset will be used

– This called the MATCHING PRINCIPLE – one of the fundamental accounting principles

• Depreciation may be used for calculating the Profit for the purposes of tax computation

Page 11: Financial  Management    Investment  Appraisal

Calculate the Cash Flow

Question 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340

Page 12: Financial  Management    Investment  Appraisal

Time Value of Money

Page 13: Financial  Management    Investment  Appraisal

Consider the Cash Flow• Consider the cash flow timing

• Is £1 today worth more than £1 next year?• We must find some way of making the cash

flows in each year equivalent to each other

Question 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340

Page 14: Financial  Management    Investment  Appraisal

Future Value

The Value of a Lump Sum or Stream of Cash Payments at a Future Point in Time

FVn = PV x (1+r)n

• Future Value depends on:

– Interest Rate– Number of Periods – Compounding Interval

Page 15: Financial  Management    Investment  Appraisal

Future Value of £200 (4 Years, 7% Interest )

What if the Interest Rate Goes Up to 8% ?

0 1 2 3 4

PV = £200

End of Year

FV1 = £214

FV2 = £228.98

FV3 = £245

FV4 = £262.16

Page 16: Financial  Management    Investment  Appraisal

Future Value of £200 (4 Years, 8% Interest )

0 1 2 3 4

PV = £200

End of Year

FV1 = £216

FV2 = £233.28

FV3 = £251.94

FV4 = £272.10

Compounding – The Process of Earning Interest in Each Successive Year

Page 17: Financial  Management    Investment  Appraisal

Periods

0%Futu

re V

a lue

of O

n e P

ound

(£)

1.000 2 4 6 8 10 12 14 16 18 20 22 24

10.00

15.00

20.00

25.00

30.00

5.00

10%

5%

15%

20%

The Power Of Compound Interest

40.00

Page 18: Financial  Management    Investment  Appraisal

Present Value

Today's Value of a Lump Sum or Stream of Cash Payments Received at a Future Point in Time

nn rPVFV 1

nn

rFV

PV)1(

Page 19: Financial  Management    Investment  Appraisal

Present Value of £200 (4 Years, 7% Interest )

What if the Interest Rate Goes Up to 8% ?

0 1 2 3 4

Discounting

PV = £200

FV1 = £214 FV2 = £228.98 FV3 = £245 FV4 = £262.16

End of Year

Page 20: Financial  Management    Investment  Appraisal

Present Value of £200 (4 Years, 8% Interest )

0 1 2 3 4

Discounting

PV = £200

FV1 = £216 FV2 = £233.28 FV3 = £252 FV4 = £272.10

End of Year

Page 21: Financial  Management    Investment  Appraisal

The Power Of High Discount Rates

Periods

Pres

ent V

alu e

of O

ne P

o und

(£)

0 2 4 6 8 10 12 14 16 18 20 22 24

0.5

0.75

1.00

0.25 10%

5%

15%20%

0%

Page 22: Financial  Management    Investment  Appraisal

Present Value Summary

• Much Of Finance Involves Finding Future And (Especially) Present Values

• Central To All Financial Valuation Techniques

• Techniques Used By Investors & Firms Alike

Page 23: Financial  Management    Investment  Appraisal

Discounting the cash flow: Question 6• Cost of Capital is 10%

Question 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340Discount Factor 0.909 0.826 0.751 0.683 0.621 0.564PV of Cash Flow 200.230 28.523 25.930 27.235 33.017 30.015 55.510NPV 0.230

Page 24: Financial  Management    Investment  Appraisal

Other Methods of Investment Appraisal• Payback period• How long is it before we get our money

backQuestion 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340Discount Factor 0.909 0.826 0.751 0.683 0.621 0.564PV of Cash Flow 200.230 28.523 25.930 27.235 33.017 30.015 55.510NPV 0.230Payback -270.000 -238.625 -207.250 -171.000 -122.660 -74.320 24.020Payback 5 Years 9 Months

Page 25: Financial  Management    Investment  Appraisal

Payback Period Critique

• Measures how long funds are at risk• Simple to calculate• BUT• Does not take into account cash flows

after the payback

Page 26: Financial  Management    Investment  Appraisal

Other Methods of Investment Appraisal• Accounting Rate of Return (ARR)Question 6

Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340Discount Factor 0.909 0.826 0.751 0.683 0.621 0.564PV of Cash Flow 200.230 28.523 25.930 27.235 33.017 30.015 55.510NPV 0.230Payback -270.000 -238.625 -207.250 -171.000 -122.660 -74.320 24.020Payback 5 Years 9 MonthsCash Flow 31.375 31.375 36.250 48.340 48.340 48.340Depreciation 25.000 25.000 25.000 25.000 25.000 25.000Profit 6.375 6.375 11.250 23.340 23.340 23.340Average Profit 15.670ARR Initial 8%ARR Average 13%

Page 27: Financial  Management    Investment  Appraisal

Accounting Rate of Return Critique

• Does not take account of timing of cash flows

• Spreads costs of assets over asset life• Reality is that cash flows out when

asset is purchased– Profit is a Concept– Cash is a Reality

Page 28: Financial  Management    Investment  Appraisal

Other methods

• Internal Rate of Return– Similar to Net Present Value

• Involves calculating which rate of return will make Net Present Value = zero and comparing this with required rate of return

• Inferior to NPV– More complex to calculate– Can give multiple rates if large negative

cash flows at end of project

Page 29: Financial  Management    Investment  Appraisal

The Manager’s Duty• Invest in projects that yield a return greater

than the minimum acceptable rate.– Returns on projects should be measured based on

cash flows generated and the timing of these cash flows

– The minimum acceptable rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)

– they should also consider both positive and negative side effects of these projects