Investment Appraisal

2BUS0197 – Financial Management

Learning outcomesBy the end of this session students should appreciate:

The main investment appraisal methods

The reasons why discounted cash flow methods are preferred

Why net present value is regarded as superior to internal rate of return

Capital rationing and investment appraisal

The role of taxation, inflation, risk and uncertainty on investment decisions

The application of sensitivity analysis to investment projects

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The net present value method

Uses discounted cash flows to evaluate capital investment projects

A cost of capital or target rate of return is used to discount all cash inflows to their present values

The present value of all cash inflows is then compared to the present value of all cash outflows

A positive net present value indicates that an investment project is expected to give a return in excess of the cost of capital and will therefore increase shareholder wealth

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The net present value method

where:

I0 is the initial investment

C1, C2, …, Cn are the project cash flows occurring in years 1, 2, …, n

r is the cost of capital or required rate of return

N.B. Cash flows occurring during a time period are assumed to occur at the end of that period

Decision rule: accept all independent projects with a positive net present value

With mutually exclusive projects, select project with highest NPV

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Example A project costing £1,000 is expected to yield £500 per

year for 2 years. Calculate its NPV

Year Cash flow 10% PVF PV

0 (1,000) 1.000 (1,000)

1 500 0.909 455

2 500 0.826 413

NPV = (132)

Question: Would you accept the project?

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Pros and cons of NPV method Advantages:

Accounts for the time value of money Uses cash flows, not accounting profit Takes into account timing and amount of project cash

flows Takes account of all relevant cash flows over the life of a

project

Disadvantages: Accepting all projects with positive NPV only possible in a

perfect capital market Cost of capital may be difficult to find Cost of capital may change over project life, rather than

being constant6

The internal rate of return (IRR) method

IRR of an investment project is the cost of capital or required rate of return which, when used to discount the cash flows from a project, produces a net present value of zero

where:

I0 is the initial investment

C1, C2, …, Cn are the project cash flows occurring in years 1, 2, …, n

r* is the internal rate of return

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The internal rate of return (IRR) method

The IRR method involves calculating the IRR of a project by linear interpolation and then comparing it with a target rate of return (or hurdle rate)

Decision rule: accept all independent investment projects with an IRR greater than the company’s cost of capital or target rate of return

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Internal rate of return

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Investment project

Discount rateIRR

NPV

0

_

10% 18%

£9,500

£3,000

Estimating the IRR of a project

In the previous example, the NPV for r = 18% is negative, while the NPV for r = 10% is positive

Hence, the IRR giving a zero NPV falls between 10 and 18%.

Using linear interpolation it is possible to estimate the IRR by applying the following formula:

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Comparing NPV and IRR methods

Mutually exclusive projects: If IRR is used, the wrong project may be selected. NPV always gives the correct selection advice

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Discount rate

IRR of incremental project

0

_

NPV

+

Cost of capital

Project B Project A

Area of conflict

Comparing NPV and IRR methods

Non-conventional cash flows: If an investment project has cash flows of different signs in successive periods (i.e. non-conventional cash flows), it may have more than one IRR

Applying the IRR method to projects with non-conventional may result in incorrect decisions being taken

The NPV method can accommodate non-conventional cash flow, hence it gives the correct selection advice

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The basic cash flow profiles

IRR and NPV with non-conventional cash flows

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+NPV

_

Discount rate

IRR1 IRR2

RA RB

Cost of capital = RA

•Project accepted by IRR method since IRR1> RA and IRR2> RA

•Project rejected by NPV method because NPV<0 for RA

Cost of capital = RB

•NPV>0, so accept project

•IRR does not offer clear advice since IRR1 < RB < IRR2

Comparing NPV and IRR methods

Changes in the discount rate: NPV can accommodate changes in the discount rate over the life of an investment project, while IRR ignores them

Reinvestment assumptions: NPV method assumes that cash flows from project can be reinvested at a rate equal to the cost of capital. IRR method assumes that cash flows can be reinvested at a rate equal to IRR. NPV reinvestment assumption is realistic

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The payback method

The payback period is the number of years it is expected to take to recover the original investment from the net cash flows resulting from a capital investment project

Decision rule: accept a project if its payback period is equal or less than a predetermined target value

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Example: a simple investment project

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The above cash flows refer to an investment project that requires a cash investment at the start of the project, followed by a series of cash inflows over the life of the project (conventional project)

Question: What is the payback period for the above project?

Pros and cons of payback method

Advantages: Simple and easy to apply Should not be open to manipulation as it uses cash flows,

not accounting profit Accounts for risk as it implicitly assumes that a shorter

payback period is superior

Disadvantages: Ignores time value of money Does not consider the project as a whole since cash flows

outside the payback period are taken into account only out of managerial judgement

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The return on capital employed method ROCE can be defined as:

average annual accounting profit × 100 average investment

Where average investment is: (initial investment + scrap value)/2

ROCE can also be defined as:

average annual accounting profit × 100 initial investment

ROCE is also known as accounting rate of return (ARR) and return on investment (ROI)

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The return on capital employed method

Average annual accounting profit can be calculated from project cash flows by taking off depreciation

Accounting profit is not cash flow since depreciation does not correspond to a cash movement

Decision rule: accept project if ROCE is equal to or greater than target (or hurdle) rate of return (i.e. current company or division ROCE)

If projects are mutually exclusive, the project with the highest ROCE should be selected

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Example

A machine costs £10,000 and its useful economic life is 5 years. After 5 years, the machine’s scrap value is £2,000. The net cash inflows from the machine would be £3,000 per year. Ignore taxation

Depreciation: (10,000 – 2,000)/5 = £1,600

Average annual profit: 3,000 – 1,600 = £1,400

Average investment: (10,000 + 2,000)/2 = £6,000

ROCE: (1,400/6,000) × 100 = 23%

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Pros and cons of ROCE method Advantages:

Measured in %, so comparable with company’s ROCE Fairly simple to apply Can be used to compare mutually exclusive projects Considers all cash flows arising during a project’s life,

unlike payback method

Disadvantages: Uses accounting profit rather than cash Profit not directly linked to primary financial objective of

shareholder wealth maximisation Uses average profits and hence ignores timing of profits Ignores time value of money Relative measure and so ignores size of initial investment

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Recap on investment appraisal methods

NPV is academically preferred as an investment appraisal method – it has no major defects and is consistent with shareholder wealth maximisation

IRR comes a close second and can prove to be a useful alternative

ROCE and payback methods are flawed as investment appraisal methods but payback is often used as an initial screening method

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Capital rationing

Hard capital rationing: limitations are externally imposed

Capital markets may be depressedInvestors may consider the company to be too risky to invest inIssue costs may make a small issue of finance expensive

Soft capital rationing: limitations are internally imposed. Arises if managers

Want to avoid dilution of controlWant to avoid dilution of EPS Wish to avoid fixed interest payments (debt)Wish to follow policy of steady growthBelieve restricting available funds will encourage better investment projects

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Arises if a firm has insufficient funds to invest in all projects with positive NPV

Single period rationing Firm must choose combination of projects to

maximise total NPV

Ranking divisible projects by NPV will not lead to correct decision

Divisible projects must be ranked using the profitability index (PI):

PI = PV of future cash flowsInitial investment

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Single period rationing

For indivisible projects, selection must be made by looking at total NPVs of possible combinations of projects

The combination with highest NPV, which does not exceed capital rationing limit will be optimal investment schedule

The investment of surplus funds is not relevant to the investment decision

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Multi-period period rationing

Profitability index and NPV evaluation of project combinations do not help

Linear programming must be used to determine the optimum combination

Simple problems can be solved by hand, complex problems by computer

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Relevant project cash flows Relevant cash flows are incremental cash flows arising

from an investment decision, such as initial investment, cash from sales and direct costs

Usually exclude: Sunk costs – incurred prior to the project start, hence not

relevant to project appraisal (e.g. market research) Apportioned fixed costs – excluded from project evaluation as

are incurred regardless of whether a project is undertaken (e.g. rent)

Usually include: Opportunity costs – if an asset is used for a project, relevant to

know what benefit has been foregone Incremental working capital – increase in working capital will be

a cash outflow for the company relevant for the project appraisal27

Optimising capital investment decisions

The investment appraisal process must account for:

The effects of taxation and inflation on project cash flows

The required rate of return

The risk and uncertainty to which future cash flows are subject

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Taxation Tax relief on capital expenditure is given through

capital allowances

In the UK: 25% reducing balance capital allowances given on plant and

machinery

100%, 50% and 40% first-year allowances have been offered for specific investments

In the last year of an investment project a balancing allowance is needed in addition to a capital allowance to ensure that the capital value consumed by the firm over the project’s life has been deducted in full in calculating taxable profits

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Taxation

Tax liability arises on taxable profits

Tax relief is available on allowable costs, such as materials, wages and maintenance

Interest payments are not relevant cash flows as these are included in the discount rate

After-tax cash flows must be discounted with a relevant after-tax cost of capital

Timing of tax liabilities and benefits should be considered

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Inflation Inflation can adversely affect capital investment

decisions by reducing the real value of future cash flows and increasing their uncertainty

Future cash flows must be adjusted to take into account any expected inflation

The real cost of capital is found from the nominal (or money) cost of capital by making an adjustment for inflation:

(1 + n) = (1 + r) × (1 + i) hence (1 + r) = (1 + n)

(1 + i)

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Risk and uncertainty

Risk refers to a set of unique circumstances, which can be assigned probabilities

Uncertainty implies probabilities cannot be assigned to different sets of circumstances

In practice, the terms ‘risk’ and ‘uncertainty’ are often used interchangeably

The business risk of an investment increases with the variability of returns

Uncertainty increases with project life

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Sensitivity analysis A method of evaluating project risk by examining how

responsive the NPV of a project is to changes in the variables from which it has been calculated

Only one variable is changed at a time (i.e. variables assumed to be independent)

Two methods to measure sensitivity: Change variables by a set amount then recalculating the NPV

Finding the change in a variable which gives a zero NPV

Both methods give indication of the key variables of an investment project, i.e. small changes in these variables can have a significant adverse effect on the project

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Problems with sensitivity analysis

Only one variable at a time can be changed

No indication is given of the probability of changes in key project variables

Not really a method of analysing project risk, since probabilities are ignored

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Summary

Today we looked at:

Investment appraisal methods Comparison between NPV and IRR methods Relevant project cash flows Optimisation of capital investment decisions

Taxation Inflation Risk and uncertainty

Sensitivity analysis

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ReadingsTextbook

Watson D. and Head A., (2007), Corporate Finance Principles and Practice, 5th (4th) edition, FT Prentice Hall, Chapters 6 and 7

Research paper

Arnold, G. C., Hatzopoulos, P. D. (2000), The Theory-Practice Gap in Capital Budgeting: Evidence from the United Kingdom, Journal of Business Finance & Accounting, Vol. 27, 5, pp. 603-626

Barwise, P., Marsh, P. R., Wensley, R. (1989), Must Finance and Strategy Clash?, Harvard Business Review, September- October, pp. 85-90

Phelan, S. E. (1997), Exposing the illusion of confidence in financial analysis, Management Decision, Vol. 35, 2, pp. 163-168

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Your tutorial activities for next week

During the seminar you will be expected to work on:

Q2 p.187; Q1 p.220 (5th ed)Q2 p.179; Q2 p.206 (4th ed)

To prepare for the seminar you should answer the following practice questions:

EQL - UFM4 Textbook - Q4 p.183; Q5 p.185; Q3 p218 (5th ed)

Q4 p.176; Q5 p.178; Q4 p205 (4th ed)

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