Lecture+4+Investment+Appraisal+Mehtods+11 12

Slide 6.
56863 Managing Finance

Investment Appraisal Methods
Week 5 27/Oct/2011 Dr. Chloe Yu-Hsuan Wu

Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, Pearson Education Limited 2010
Slide 6.2
Payback period
Years to recover initial investment Example:
Year 0 1 2 3 4 Payback Project A (1000) 400 400 400 400 2.5 years Project B (1000) 600 400 200 nil 2 years
Slide 6.3
Payback period
Payback decision rule Accept the investment which recovers the initial cost the soonest (or within a predetermined time period
Slide 6.4
Payback period (Continued)

Advantages of payback period:
Simple concept to understand Easy to calculate (provided future cash flows have been calculated) Uses cash, not accounting profit Takes risk into account (in the sense that earlier cash flows are more certain).
Slide 6.5
Payback period (Continued)

Disadvantages:
Considers cash flows within the payback period only; says nothing about project as a whole Ignores time value of money Does not indicate whether the project increase the value of a company.
Slide 6.6
Accounting rate of return

The accounting rate of return (or return on capital employed) is the average annual profit divided by the average (or initial) investment Average annual profits Average investment or Average annual profits Initial investment
Slide 6.7
Accounting rate of return (Continued)

Average annual accounting profit can be calculated from project cash flows by taking off depreciation. Accounting profit is not cash flow. Simple decision rule: accept project if ROCE is equal to or greater than target value i.e. current company or division ROCE. If projects are mutually exclusive, select project with highest ROCE.
Slide 6.8

Example:
A machine costs 10 000 Useful economic life is 5 years After 5 years, scrap value of 2000 Net cash inflows from the machine would be 3000 per year Ignore taxation.
Slide 6.9

Example:
Depreciation: (10 000 2000)/5 = 1600 Average annual profit: 3000 1600 = 1400 Average investment: (10 000 + 2000)/2 = 6000 ROCE: (1400/6000) 100 = 23%
Slide 6.10

Advantages of return on capital employed:
Gives value in familiar percentage terms Can be compared with primary accounting ratio, ROCE Relatively simple concept compared to DCF methods such as NPV and IRR Can compare mutually exclusive projects Considers whole of project, unlike payback.
Slide 6.11

Disadvantages of return on capital employed
Uses accounting profit rather than cash: Uses average profits and hence ignore timing of profits Ignores time value of money Relative measure and so ignores size of initial investment.
Slide 6.12
Why is time value important?

uncertainty of the future inflation money invested now can make a profit in the future
Slide 6.13
Net present values

Evaluates an investment by comparing the PV of future cash flows at an assumed cost of capital and the capital outlay of the investment
Regarded as the best investment appraisal method by academics Decision rule: select the investment with a + NPV choice of investment: select the investment with the highest NPV
Slide 6.14
Net present value (Continued)

NPV is given by:
I0 + + + + . . .+ (1+r) (1+r)2 (1+r)3 (1+r)n
_____
C1
_____
C2
_____
C3
____
Cn
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.
Slide 6.15

Example:
Project costing 1000 is expected to yield 500 per year for 2 years. What is the NPV?
Year 0 1 2 Cash flow (1000) 500 500 10% PVF 1.000 0.909 0.826 NPV = PV (1000) 455 413 (132)
Would you accept the project? No.

Slide 6.16

Advantages:
Takes account of time value of money Uses cash flow, not accounting profit Takes account of all relevant cash flows over life of project Gives absolute measure of project value.
Slide 6.17

Disadvantages:
Project cash flows may be difficult to estimate (but applies to all methods) 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 constant.
Slide 6.18
Internal rate of return
IRR is discount rate which gives zero NPV for project. Decision rule is to accept all projects with an IRR greater than company's cost of capital or target rate of return.
Slide 6.19
Internal rate of return (Continued)

+
NPV
IRR
Discount rate
Investment project
Slide 6.20
Internal rate of return (Continued)

C1 C2 C3 Cn
+ _____ + _____ + . . .+ ____ (1+r) (1+r)2 (1+r)3 (1+r)n
_____
I0
Where: I0 is the initial investment C1, C2, . . Cn are the project cash flows occurring in years 1, 2, . . n r is internal rate of return.
Slide 6.21
IRR versus NPV

If IRR is used to compare mutually exclusive projects, wrong project may be selected: NPV always gives correct selection advice.
+ NPV Area of conflict
Discount rate IRR of incremental project Cost of capital
Project B
Project A
Slide 6.22
IRR versus NPV (Continued)

A problem if applying IRR to projects with nonconventional cash flows is that multiple IRRs may be found: again, NPV gives correct selection advice. NPV can accommodate changes in discount rate during project, but IRR ignores them. NPV method assumes that cash flows can be reinvested at a rate equal to the cost of capital: IRR method assumes that cash flows can be reinvested at rate equal to IRR.
Slide 6.23
Conclusion
NPV is academically preferred as an investment appraisal method it has no major defects. IRR comes a close second and can prove to be a useful alternative. ARR and payback are flawed as investment appraisal methods but payback is often used as an initial screening method.
Slide 6.24
Other factors
Taxation
Capital allowance Tax relief
Inflation
Real value of future cash flow
Risk and uncertainty
Slide 6.25
Reading
Textbook : chapter 6, 7

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Slide 6.

56863 Managing Finance

Week 5 27/Oct/2011 Dr. Chloe Yu-Hsuan Wu

Payback period (Continued)

Payback period (Continued)

Accounting rate of return

Accounting rate of return (Continued)

Accounting rate of return (Continued)

Accounting rate of return (Continued)

Accounting rate of return (Continued)

Accounting rate of return (Continued)

Why is time value important?

Net present values

Net present value (Continued)

Net present value (Continued)

Would you accept the project? No.

Net present value (Continued)

Net present value (Continued)

Internal rate of return

Internal rate of return (Continued)

Internal rate of return (Continued)

+ _____ + _____ + . . .+ ____ (1+r) (1+r)2 (1+r)3 (1+r)n

IRR versus NPV

Discount rate IRR of incremental project Cost of capital

IRR versus NPV (Continued)

Risk and uncertainty

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+ ___ + _ + . . .+ __ (1+r) (1+r)2 (1+r)3 (1+r)n