The BSC is a balance between:

Capital Investment Appraisal

Investment Appraisal

What is investment appraisal?

The appraisal techniques

The complications

Summary and Review

What is investment appraisal?

Cash out now in return for cash in later

Includes capital expenditure:

Acquisition of a company

Purchase of an asset

Investment in systems

Expansion of working capital

Also may include revenue expenditure:

Branding

R&D

Systems development

Training

The importance of investment appraisal

Capital projects may be:

large and long-term

essential to business strategy

determinants of future success

Need an effective appraisal process for:

Generation of ideas

Solving problems and taking opportunities

Identifying the options/alternatives

Gathering information

Analysis and evaluation

Presentation

Audit

Should it be left to the accountants?

The managers input is critical!

The Investment Appraisal Model

Equity Finance

Secondary Investment in Projects

Debt Finance

Equity Finance

Primary Investment in the Company

Funds

Funds

Funds

Returns

Returns

Returns

WACC

RRR

Interest

Investment Appraisal

The Techniques:

Accounting Rate of Return

Payback

Net Present Value

Internal Rate of return

Cash Flows?

Profit or

PaybackNet Present ValueInternal Rate of return

Consider Two Projects:

Both projects require investment new plant with a life of 4 years:-

Project AProject BInitial Investment20,00022,000

The investments will result in the following estimated cash flows and profits:-

PROJECT AYearNet Cash FlowDepreciationProfit19,0005,0004,00028,0005,0003,00037,0005,0002,00045,5005,000500TOTAL29,50020,0009,500

PROJECT BYearNet Cash FlowDepreciationProfit17,0005,5001,50028,0005,5002,50039,0005,5003,50049,0005,5003,500TOTAL33,00022,00011,000

Tear off the back page

Accounting Rate of Return

= Average Annual Profits Average Capital Employed

Project AProject B

Average Profits == 2,375

Average C.E. == 10,000

ARR == 23.75%

Should C.E. include Working Capital?

YES

11,0004

= 2750

22,000 + 02

= 11,000

2,75011,000

= 25%

ARR - Decision Criteria

Accept projects with ARR greater than company's present (or target) ROI

Advantages of ARR:

Simple

Uses normal reporting conventions

Considers whole project

Comparable with ROI

Disadvantages of ARR:

Uses profit not cash flows

Ignores timing of profits

Not an absolute measure

Payback

Time taken for net cash flows to exceed the initial outlay

PROJECT A:-YearNet Cash FlowsCumulative Cash Flows0(20,000)(20,000)19,000 (11,000)28,000 (3,000)37,000 4,000 45,500 9,500 Payback = 2 years, 5 months

PROJECT B:-YearNet Cash FlowsCumulative Cash Flows0(22,000)17,000 28,000 39,000 49,000 Payback = years, months

2

9

3000 x 12 7000

2 years +

(22,000)

(15,000)

(7,000)

2 years +

7000 x 12 9000

Payback - Decision Criteria

Accept projects with payback shorter than the company's target payback

Advantages of Payback:

Simple

Favours quick return

Tests liquidity

Minimises time related risk

Disadvantages of Payback:

Ignores overall profitability

Ignores receipts after payback

Ignores timing of cash flows

Not an absolute measure

The time value of money

Why is 100 now worth more than 100 next year?

1.

2.

3.

Opportunity cost

Inflation

Risk

So my friend must repay me 1100 in 1 years My 1000 will have a value of 1100 in one years time.

(1100 is its Future Value)

A cash Flow of 1100 in a years time is equivalent to 1000 now

(1100 has a Present Value of 1000)

We now have a way of converting future cash flows to a common basis the Present Value

Return

Inflation

Risk

Opportunitycost

I agree to lend a friend 1000How much should I expect as repayment?In practice I might want a 10% return (my opportunity cost)

Present value, P = = S(1 + r)-n

Note: Present value tables show the result of (1 + r)-n for various interest rates and years.Discounting at 10%, what is the present value of 100 received annually for three years, starting next year?

YearCash FlowsPV factorPresent value11000.909 90.921000.82682.631000.75175.1248.6

b) Discounting:-

Present Value Tables:

Value of 1 to be received in n years time at a discount rate of r%

Present value, P = = S(1 + r)-n

Note: Present value tables show the result of (1 + r)-n for various interest rates and years.Discounting at 10%, what is the present value of 100 received annually for three years, starting next year?

YearCash FlowsPV factorPresent value11000.909 90.921000.82682.631000.75175.1248.6

b) Discounting:-

Annuity Tables:

Present value of 1 per year for n years at discount rate r, starting one year hence.

Present value, P = = S(1 + r)-n

Note: Present value tables show the result of (1 + r)-n for various interest rates and years.Discounting at 10%, what is the present value of 100 received annually for three years, starting next year?

YearCash FlowsPV factorPresent value11000.909 90.921000.82682.631000.75175.1 248.6

b) Discounting:-

2.486

100 x

= 248.6

What is the NPV of A and B if the company's
pre-tax weighted average cost of capital is 18%?

Project A:YearNet Cash FlowsPV factorNPV0(20,000)1(20,000)19,0000.8477,623 28,0000.7185,744 37,0000.6094,263 45,5000.5162,838 Project Net Present Value 468 Project B:YearNet Cash FlowsPV factorNPV0(22,000)1(22,000)17,0000.8475,929 28,0000.7185,744 39,0000.6095,481 4 9,000 0.5164,644 Project Net Present Value (202)

Shows increase in Shareholders wealth NOW

NPV - Decision Criteria

Accept projects with positive NPV when discounted at company's weighted average cost of capital (WACC)

Advantages of NPV:

Uses cash flows not profits

Considers whole project

Takes account of time value of money

An absolute measure

Disadvantages of NPV:

Complex

Only as accurate as the cash flow estimates

Need to know company's WACC

Internal Rate of Return (IRR)

The discount rate that equates the NPV offuture cash flows to the initial investment.Project A:YearNet Cash PV Factor NPV PV Factor NPV Flowat 18% at 18% at 20%at 20%0(20,000)1(20,000)1(20,000)19,000 0.8477,623 0.8337,497 28,000 0.7185,744 0.6945,552 37,000 0.6094,263 0.5794,053 45,500 0.5162,838 0.4822,651 Project Net Present Value468 (247)

The IRR of Project A is approximately 19%

Interpolation to find the IRR

NPV

468Estimated IRR

018%20%r

-247

Real IRR

Project B:YearNet CashPV Factor NPV PV Factor NPV Flowat 18% at 18% at at 0(22,000)1(22,000) 17,000 0.8475,929 28,000 0.7185,744 39,000 0.6095,481 49,000 0.5164,644 Project Net Present Value(202)

The IRR of Project B is approximately %

N.B.IRR is also called:

DCF Yield

Marginal efficiency of capital

Discounted yield

Actuarial Rate of Return

10.8620.7430.6410.552

16%

16%

(22,000)

6034

5944

5769

4968

715

17.5

Accept projects with IRR greater than company's weighted average cost of capital (WACC).

IRR - Decision Criteria

NPV and IRR compared:

With conventional cash flows NPV and IRR give same ranking

With non-conventional cash flows may be no IRR or multiple IRRs.

NPV is absolute but IRR is relative.

If discount rates alter over projects' life can use NPV but not IRR.

Different reinvestment assumptions:

NPV assumes reinvestment at discount rate

IRR assumes reinvestment at IRR

Summary of Results

ProjectABARR23.8%25%Payback2 yrs 5 mths2 yrs 9 mthsNPV at 18%468(202)IRR19.3%17.5%

What is used in practice?

1975 1980 1986 1992 % % % %Payback 73 81 92 94

Accounting Rate of Return 51 49 56 50

Internal Rate of Return 44 57 75 81

Net Present value 32 39 68 74

Capital Investment Techniques used by UK companies

Pikes Survey of 100 large UK firms 1988 and 1996

Capital Investment Techniques used by UK companies

Arnold and Hatzopoulos 1997 Survey of 300 UK companies in top 1000

Small Medium Large Total %% % %Payback 7175 66 70

ARR 6250 55 56

IRR 7683 84 81

NPV 6279 97 80

The Complications

Inflation

Taxation

Risk

Qualitative Factors

Pragmatic Approach to Risk

RRR

WACC

RiskOnly use WACC to discount projects of normal risk!

Low

SML

Medium

High

SecuritiesMarketLine

Or..apply sensitivity analysis.

Two methods of accounting for risk:

Adjust the discount rate to reflect the increased required rate of return of shareholdersdue to the uncertainty of the cash flows.

Adjust the cash flows to more certain figures = sensitivity analysis.

Should you use both methods together?

NO

Sensitivity Analysis

Measures the change necessary to reduce NPV to zero

Thus shows which are the sensitive elements of the project

How to do it???

Consider each component of the calculation in turn

keeping all others constant

Work out change in that element necessary

to reduce NPV to zero

Express this as a % change on original figure.

Lowest % change is most sensitive

Project A- Sensitivity

Year

01234

Net CashFlows

NCFLess 10%

(20000)9000800070005500

(20000)8100720063004950

PV Factor

10.8470.7180.6090.516

PV

(20000)6860517038372554(1579)

A 10% change in NCF= reduction from 468 to (-1579)ie a change of 2047 in NPVSo a 1% =204.7 reduction To reduce NPV to zero will require a fall in NCF of 468/204.7=2.3%

This can be repeated for

initial investment,

life of project and

discount rate

In addition if available also look at

Sales price

Sales volume

Costs

Scrap values

This then builds a profile of which are

the most sensitive elements.

(usually sales price and volume will be the most sensitive)

Management can then evaluate if they feel the

sensitivity is acceptable

Sensitivity

Risk

Other methods include:

Expected values (assigning probabilities to outcomes)

Simulation

Adjust discount rate to include a risk premium

Hurdle rates

Some firms will use a hurdle ( target) rate

This may incorporate an arbitrary?? element to cover risk

It can lead to a profitable project being rejected

Example

A company has a cost of capital of 12%It uses a hurdle rate of 20% to assess projectsA project with an NPV of say 1m at 12% may have an NPV of -0.5m at 20%(Its IRR may be say 16%)

The company would reject this project thus losing the opportunity to increase shareholder wealth

Inflation

Cost of Capital incorporates inflation assumptions

Cash flows must therefore be be in money (i.e. inflated) terms

Different rates may apply to different items

Taxation

Tax charged on profits (30%)

Tax paid during and after the year on an estimated basis

Capital Expenditure can reduce liability (Capital Allowances at 25% of reducing balance)

Normally tax will reduce NPV and may make project unviable

CAPITAL RATIONING 1

Exists when there is a limit on capital

Need to select the combination of projects which

gives the best NPV

This is found by calculating the NPV per of investment

This is known as the Profitability Index

Profitability Index = NPV

Investment

Use projects with highest PI first

CAPITAL RATIONING 2

Cash flows m

ProjectC0C1C2 NPV@10%

A-20+60+10 42B-10+10+40 32C-10+10+30 24

Only 20m is available

Project InvestmentNPVProfitability IndexA2042 2.1B1032 3.2C1024 2.4

Choose B+C to give total NPV = 56mA only has NPV of 42m

CAPITAL RATIONING 3

If we have 30m to invest the problem gets more complicated

If we can do part of a project then we do all of B32all of C24half of A21Total NPV77

If we can only do whole projects then we must select the best combination

all of B32all of A42Total NPV 74

This is most easily done by trial and error

SUMMARYCAPITAL RATIONING

Applies when there is a limit on capital available

Must make best use of Capital

Rank projects by Profitability Index

i.e. NPV invested

Choose projects with highest PI first

If a portion of a project can be undertaken then use

up capital by adopting a proportion of a project.

If portions cannot be undertaken then necessary to

choose the optimal mix of projects.

This can be done by trial and error if only a small number

of projects are available.

.and finally

Do not judge by numbers alone:

Perform Sensitivity Analysis

Consider qualitative factors

These may be more important than the figures!

Perform a post completion audit:

Internal but independent

Control the project throughout

Justification becomes Budget

How good were estimates?

Learn from the audit.be right next time!

Relevant Costs and Revenues

Sunk costs are irrelevant.

Committed costs are sunk.

Consider only future costs and revenue

that arise as a result of the decision.

What is the capacity position?

Consider opportunity costs.

Summary & Review

Good Investment Appraisal is critical to success

Managers input is crucial

Relevant to minimising costs and maximising profits

Need to identify and use relevant cash flows

Qualitative issues need to be fully considered

Cant ignore risk

Conduct sensitivity analysis

There are other complications:

e.g. Taxation, Inflation, Capital rationing

Consider Two Projects:

Both projects require investment new plant with a life of 4 years:-

Project AProject BInitial Investment20,00022,000

The investments will result in the following estimated cash flows and profits:-

PROJECT AYearNet Cash FlowDepreciationProfit19,0005,0004,00028,0005,0003,00037,0005,0002,00045,5005,000500TOTAL29,50020,0009,500

PROJECT BYearNet Cash FlowDepreciationProfit17,0005,5001,50028,0005,5002,50039,0005,5003,50049,0005,5003,500TOTAL33,00022,00011,000

Tear off the back page

n1%2%3%4%5%6%7%8%9%10%11%12%13%14%15%16%17%18%19%20%

10.9900.9800.9710.9620.9520.9430.9350.9260.9170.9090.9010.8930.8850.8770.8700.8620.8550.8470.8400.833

20.9800.9610.9430.9250.9070.8900.8730.8570.8420.8260.8120.7970.7830.7690.7560.7430.7310.7180.7060.694

30.9710.9420.9150.8890.8640.8400.8160.7940.7720.7510.7310.7120.6930.6750.6580.6410.6240.6090.5930.579

40.9610.9240.8880.8550.8230.7920.7630.7350.7080.6830.6590.6360.6130.5920.5720.5520.5340.5160.4990.482

50.9510.9060.8630.8220.7840.7470.7130.6810.6500.6210.5930.5670.5430.5190.4970.4760.4560.4370.4190.402

60.9420.8880.8370.7900.7460.7050.6660.6300.5960.5650.5350.5070.4800.4560.4320.4100.3900.3700.3520.335

70.9330.8710.8130.7600.7110.6650.6230.5830.5470.5130.4820.4520.4250.4000.3760.3540.3330.3140.2960.279

80.9230.8530.7890.7310.6770.6270.5820.5400.5020.4670.4340.4040.3760.3510.3270.3050.2850.2660.2490.233

90.9140.8370.7660.7030.6450.5920.5440.5000.4600.4240.3910.3610.3330.3080.2840.2630.2430.2250.2090.194

100.9050.8200.7440.6760.6140.5580.5080.4630.4220.3860.3520.3220.2950.2700.2470.2270.2080.1910.1760.162

110.8960.8040.7220.6500.5850.5270.4750.4290.3880.3510.3170.2870.2610.2370.2150.1950.1780.1620.1480.135

120.8870.7880.7010.6250.5570.4970.4440.3970.3560.3190.2570.2310.2080.1870.1680.1520.1370.1240.1120.069

130.8790.7730.6810.6010.5300.4690.4150.3680.3260.2900.2580.2290.2040.1820.1630.1450.1300.1160.1040.093

140.8700.7580.6610.5770.5050.4420.3880.3400.2990.2630.2320.2050.1810.1600.1410.1250.1110.0990.0880.078

150.8610.7430.6420.5550.4810.4170.3620.3150.2750.2390.2090.1830.1600.1400.1230.1080.0950.0840.0740.065

n1%2%3%4%5%6%7%8%9%10%11%12%13%14%15%16%17%18%19%20%

10.990.980.970.960.950.940.930.930.920.910.900.890.880.880.870.860.850.850.840.83

21.971.941.911.891.861.831.811.781.761.741.711.691.671.651.631.611.591.571.551.53

32.942.882.832.782.722.672.622.582.532.492.442.402.362.322.282.252.212.172.142.11

43.903.813.723.633.553.473.393.313.243.173.103.042.972.912.852.802.742.692.642.59

54.854.714.584.454.334.214.103.993.893.793.703.603.523.433.353.273.203.133.062.99

65.805.605.425.245.084.924.774.624.494.364.234.114.003.893.783.683.593.503.413.33

76.736.476.236.005.795.585.395.215.034.874.714.564.424.294.164.043.923.813.713.60

87.657.337.026.736.466.215.975.755.535.335.154.974.804.644.494.344.214.083.953.84

98.578.167.797.447.116.806.526.256.005.765.545.335.134.954.774.614.454.304.164.03

109.478.988.538.117.727.367.026.716.426.145.895.655.435.225.024.834.664.494.344.19

1110.379.799.258.768.317.897.507.146.816.506.215.945.695.455.235.034.844.664.494.33

1211.2610.589.959.398.868.387.947.547.166.816.496.195.925.665.425.204.994.794.614.44

1312.1311.3510.639.999.398.858.367.907.497.106.756.426.125.845.585.345.124.914.714.53

1413.0012.1111.3010.569.909.298.758.247.797.376.986.636.306.005.725.475.235.014.804.61

1513.8712.8511.9411.1210.389.719.118.568.067.617.196.816.466.145.855.585.325.094.884.68