Week 1 investment appraisal

FINANCIAL MANAGEMENTPrepared by Tishta Bachoo

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Lecture 1 - overview

Prepared by Tishta Bachoo

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• Introduction to financial management

• Investment Appraisal & its techniques• Payback period• Net Present Value (NPV)• Accounting Rate of Return (ARR)• Profitability Index (PI)

What is Financial Management?

Financial management means to plan and control the finance of the company. It is done to achieve the objectives of the company.

Financial management is concerned with raising financial resources and their effective utilization towards achieving the organizational goals.


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http://kalyan-city.blogspot.com/2011/04/what-is-management-definitions-meaning.html

http://kalyan-city.blogspot.com/2010/06/planning-first-primary-important.html

http://kalyan-city.blogspot.com/2010/06/organisation-organizational-structure.html

One of the duty of a financial manager is to choose investments with satisfactory cash flows and rates of return.

Therefore, a financial manager must be able to decide whether an investment is worth undertaking and be able to choose intelligently between two or more alternatives.

To do this, a sound procedure to evaluate, compare, and select projects is needed. This procedure is called Investment Appraisal.


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As investments involve large resources, wrong investment decisions are very expensive to correct

Managers are responsible for comparing and evaluating

alternative projects so as to allocate limited resources and maximize the firm’s wealth

Some basic techniques of making capital investment appraisal for evaluating proposed capital investment projects


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Payback period


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Payback period

The payback period is the most basic and simple decision tool.

Payback period is the period of time it takes for a company to recover its initial investment in a project

The method measures the time required for a project’s cash flow to equalize the initial investment


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Acceptance criterion


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< Number of years Accept the project

> Number of years Reject the project

Advantages of payback period

Easy to adopt Simple to compute Provides some information on the risk of the

investment.


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Disadvantages of Payback period

Ignore the cash flows after payback period Ignores the time value of money.


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Example


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A company is considering making the following mutually exclusive

investments in the production facilities for the new products with an

estimated useful life of four years. The cash inflow and outflows are

listed as follows:

Project A Project B

Initial investment 1000000 1000000

Cash inflow at the end of year

Year 1 700000 600000

Year 2 200000 400000

Year 3 300000 400000

Year 4 1300000 400000


13Project A Project B$ $

Initial investment 1000000 1000000Discounted cash flowYear 1 700000 600000Year 2 200000 400000 Year 3 300000 400000 Year 4 1300000 400000

Payback period:

Project A 2 years and 4 months (100000/300000*12)

Project B = 2 years

Net Present Value Method


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NPV is used in investment appraisal to analyze the profitability of an INVESTMENT or project

A Net Present Value (NPV) that is positive is good (and negative is bad).

But your choice of interest rate can change things!


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http://www.investopedia.com/terms/n/npv.asp

Calculation procedures

1. Determining the discount rate

2. Calculating the NPV:


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NPV = FV1 FV2 FV3 FVn

(1+r)1 (1+r)2 (1+r)3 (1+r)n+ + + - I0

where FV = future value of an investmentn = no. of yearsr = Rate of return available on an equivalent risk security in the financial marketI 0= initial investment

3. Interpreting the NPV derived as follows:


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NPVs Comments Reasons <0 Reject the project The rate of return from the project is

small than the rate of return from an equivalent risk investment

=0 Indifferent to accept or reject the project

The rate of return from the project is equal to the rate of return from an equivalent risk investment

>0 Accept the project The rate of return from the project is greater than the rate of return from an equivalent risk investment

Highest Accept the project If various project are considered, the project with highest positive NPV should be chosen

Example


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A company is considering making several investments in the Production facilities for the new products with an estimated usefulLife of four years. The cash inflows and outflows are listed as follows:

ProjectA B C D$ $ $ $

Initial investment 900000 1000000 303730 1500000Cash inflowYear 1 120000 400000 100000 10000Year 2 250000 400000 100000 10000Year 3 400000 400000 100000 1000000Year 4 1300000 400000 100000 1000000

The appropriate discount rate of these investment is 12%


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Required:

(a) Calculate the NPV of each investment and determine whetherto accept it or not (assuming the company has unlimitedresources)

(b) If the company has limited resources, determine which investment should be accepted by referring to the highest NPV


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Project A

NPV = 120000 250000 400000 13000001.12 1.122 1.123 1.124

+ + + - 900000

= $517327 (accepting)Project B

NPV = 40000 400000 400000 4000001.12 1.122 1.123 1.124

+ + + - 1000000

= $214920(accepting)

(a)


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Project C

NPV = 100000 100000 100000 1000001.12 1.122 1.123 1.124

+ + + - 303730

= $0 (indifferent to accept or reject)Project D

NPV = 10000 10000 1000000 10000001.12 1.122 1.123 1.124

+ + + - 1500000

= -$135801(rejecting)

(a)

(b) With limited resources, the company should only accept project A because it generates the highest NPV

Advantages of NPV

Consistency with the time value of money concept

Consideration of all cash flows

Tells whether the investment will increase the firm’s value.


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Disadvantages of NPV

Requires an estimate of the cost of capital in order to calculate the NPV

It is quite lengthy to calculate.


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Accounting Rate of Return


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Accounting rate of return

The accounting rate of return compares the average accounting profit with the average investment cost of project

The accounting profit can be expressed either before tax or after tax


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Calculation procedures


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ARR = Average net profit per year (over the life of the project)

Average investment cost

Average net profit per year =Total profit

No. of life of the project

Average investment cost = Initial investment+ cost at end

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In evaluating an investment project, the ARR of the project is compared with a predetermined minimum acceptable accounting Rate of return:

ARRs Comments< minimum acceptable rate Reject project= minimum acceptable rate Accept project> minimum acceptable rate Accept projectHighest Choose highest ARR

Acceptance criterion

Example


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A company is considering whether to buy specialized machinesFor a new production line. The purchase price of machinery is $400000 and its estimated useful life is four years. There is no scrap Value after four yearsThe project income statements:

Year1 Year 2 Year 3 Year 4$ $ $ $

Revenue 310000 280000 280000 310000Depreciation 100000 100000 100000 100000Other expenses150000 100000 110000 120000Profit before tax 60000 80000 70000 90000Taxation (15%) 9000 12000 10500 13500

51000 68000 59500 76500Should the company buy the new machinery if the minimum acceptableRate of return is 20%?


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Average net income = 51000+68000+59500+76500

4= $63750

Average investment = 400000+0 2

= $200000

The cost of machinery is $400000 at the beginningThe cost of machinery is $0 at the end as depreciation is provided On straight line method and there is no scrap value

ARR = $63750$200000 = 31.875%

Since the ARR is 31.875%, which is higher than the minimum Acceptable rate of 20%, the company should invest in the new machinery.

Advantages of ARR

It is easy to understand and compute

It avoids using gross figures. Therefore, it enables comparisons to be made between projects with different useful lives


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Disadvantages of ARR

It ignores the time value of money ARR method seems to be less reliable than the

NPV method. It adopts the accounting profit instead of cash flows calculation. The change of depreciation method may also alter the accounting profit


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Profitability Index (PI)

Profitability index

• Although a project may show the highest positive NPV compared to other alternatives, it might not be efficient in the profitable use of funds invested.

• To identify if the project uses the capital invested most efficiently, an index is calculated by comparing the present values of all net operating cash flows with the capital outlay, that is the profitability index.


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Advantages of Profitability index

PI considers the time value of money.

PI considers analysis all cash flows of the project.


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Disadvantages of Profitability index

It is difficult to understand interest rate or discount rate.

It is difficult to calculate profitability index if two projects having different useful life.


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Decision Rule


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Accept a project if the profitability index is greater than 1, stay indifferent if the profitability index is zero and don't accept a project if the profitability index is below 1.

Profitability index is sometimes called benefit-cost ratio too and is useful in capital rationing since it helps in ranking projects based on their per dollar return.

Profitability Index = Present Value of future cash flows Initial investment

Example


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A company is considering making several investments in the Production facilities for the new products with an estimated usefulLife of four years. The cash inflows and outflows are listed as follows:

ProjectA B C D$ $ $ $

Initial investment 900000 1000000 303730 1500000Cash inflowYear 1 120000 400000 100000 10000Year 2 250000 400000 100000 10000Year 3 400000 400000 100000 1000000Year 4 1300000 400000 100000 1000000

The appropriate discount rate of these investment is 12%


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Project A

NPV = 120000 250000 400000 13000001.12 1.122 1.123 1.124

+ + + - 900000

= $517327 (accepting)Project B

NPV = 40000 400000 400000 4000001.12 1.122 1.123 1.124

+ + + - 1000000

= $214920(accepting)

(a)


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Project C

NPV = 100000 100000 100000 1000001.12 1.122 1.123 1.124

+ + + - 303730

= $0 (indifferent to accept or reject)Project D

NPV = 10000 10000 1000000 10000001.12 1.122 1.123 1.124

+ + + - 1500000

= -$135801(rejecting)

(a)

Taking into accounting the previous NPV example, the project which was chosen was A with an PV of $ 1417327.

To calculate the Profitability index now, we apply the formula.

Profitability Index = Present Value of future cash flows

Initial investment

= $1417327. = 1.57 (>1) therefore accept the project.

$900000Prepared by Tishta Bachoo

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END OF LECTURE


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TUTORIAL QUESTIONS & ANSWERS

Q1. Net Present Value

Deciding on a new machine A small industrial machine costs $100 000 and is expected to earn annual net cash inflows of $44 000, $40 000, $36 000 and $32 000, before it wears out sufficiently to be unreliable and must be sold for an estimated $10 000.

Required: a. If funds earn 10 per cent, what is its NPV?

b. If funds earn 15 per cent, what is its NPV?


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A1. Net Present Value (a)NPV = Present Value of Net Cash Flows – Initial Cost

Discount rate is 10%

Present Value of Net Cash Flows using factors from the Present Value table for $1 at the end of N periods:

PV1 = $44 000 x 0.909 = $39 996

PV2 = $40 000 x 0.826 = $33 040

PV3 = $36 000 x 0.751 = $27 036

PV4 = ($10 000 + $32 000) x 0.683 = $28 686

$128 758 NPV = $128 758 - $100 000 = $28 758


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A1. Net Present Value (b)Discount rate is 15%


PV1 = $44 000 x 0.870 = $38 280

PV2 = $40 000 x 0.756 = $30 240

PV3 = $36 000 x 0.658 = $23 688

PV4 = ($10 000 + $32 000) x 0.572= $24 024

$116 232

NPV = $116 232 - $100 000 = $16 232


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Q2. Payback Period (PP)

A machine costing $102 700 is estimated to have a useful life of 5 years and is estimated to produce the following annual net cash inflows: Year Annual Net Cash Inflow 1 $21 600 2 $28 200 3 $31 600 4 $38 200 5 $42 000

Required: Calculate the payback period for the investment.


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A2. Payback Period (PP)Year Net Cash Flow Cumulative

Net Cash Flow 0 ($102 700) ($102 700) 1 $21 600 ($81 100) 2 $28 200 ($52 900) 3 $31 600 ($21 300) 4 $38 200 $16 900 5 $42 000 $58 900


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Payback occurs between years 3 and 4. Calculating the exact payback period in years and months: At the end of year 3 there is $21 300 of the initial investment left to be paid back and during year 4 the net cash inflow is $38 200. Payback period = 3 years + (21 300 ÷ 38 200 x 12 months) = 3 years 6.69 months = 3 years 7 months

Q3. Accounting Rate of Return

BlueMan, Inc. wants to purchase of a new ice cream truck with a cost of $58,000. BlueMan has a cost of capital of 8.4% and a required rate of return of 12.4%. The acquisition is proposed for January 1, 2018. BlueMan expects it can sell the new truck for $10,000 at end of its useful life of 4 years. BlueMan predicts the new truck will generate net income of $6,000 and operating cash flows of $18,000 during 2018, with an increase of $500 each subsequent year. Calculate the accounting rate of return.


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A3. Accounting Rate of Return

The accounting rate of return method uses net income instead of cash flows. The net income for the four years must be averaged. The $500 increase applies as well.

ARR=

=


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Average net incomeAverage investment

($6,000 + $6,500 + $7,000 + $7,500) / 4 years ($58,000 + $10,000) / 2

= 19.85%

A3. Accounting Rate of Return (Cont.)

The denominator averages the book value at the acquisition date with the book value at the end of the 4 year period. At the acquisition date, the cost is $58,000 and accumulated depreciation is zero, leaving a book value of $58,000. At the end of the useful life, the cost is still $58,000 but with 4 years of depreciation at $12,000 each, total accumulated depreciation will be $48,000. The book value at the end of the life is $58,000 less $48,000, or $10,000. The book value at the end of the useful life is always equal to the salvage value. The denominator is divided by 2 because 2 numbers are being averaged.

This investment is expected to generate a return of profit of almost 20% for each of the 4 years of the proposed asset's life.


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Q4. Profitability Index (a) Company C is undertaking a project at a cost of $50 million

which is expected to generate future net cash flows with a present value of $65 million. Calculate the profitability index.

(b) A small industrial machine costs $100 000 and is expected to earn annual net cash inflows of $44 000, $40 000, $36 000 and $32 000, before it wears out sufficiently to be unreliable and must be sold for an estimated $10 000. [Same question as Q1 where you have calculated the PV already]. Calculate the profitability index for both cases that is funds earn is 10% and 15% respectively.


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A4. Profitability Index (a)

Profitability Index = PV of Future Net Cash Flows / Initial Investment Required

Profitability Index = $65M / $50M = 1.3


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A4. Profitability Index (b)NPV = Present Value of Net Cash Flows – Initial Cost

Discount rate is 10%


PV1 = $44 000 x 0.909 = $39 996

PV2 = $40 000 x 0.826 = $33 040

PV3 = $36 000 x 0.751 = $27 036

PV4 = ($10 000 + $32 000) x 0.683 = $28 686

$128 758 PI= 128758/100000 = 1.28


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A4. Profitability Index (b)Discount rate is 15%


PV1 = $44 000 x 0.870 = $38 280

PV2 = $40 000 x 0.756 = $30 240

PV3 = $36 000 x 0.658 = $23 688

PV4 = ($10 000 + $32 000) x 0.572= $24 024

$116 232

PI= 116232/100000 = 1.16


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Rectifications:

For NPV and PI, in class I asked you to use interest rate of 12%, However, in the tutorial solutions on PowerPoint, I have used 15% as it was initially.


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END OF SESSION

Next week …

Decision-Making techniques:-To accept or reject special orders-To make or to buy-Decision when there is a limiting factor


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Week 1 investment appraisal

Economy & Finance

Transcript of Week 1 investment appraisal