5016 - Investment and Financial Analysis - Investment Appraisal Part 1 - Traditional Methods and Discounted Cash Flow Methods p218 - 284 Flashcards
What is the simplified Capital Investment Process
Search Screening Definition Evaluation Approval
Summary of the Search phase of the Capital Investment Process
Identify Opportunities
Summary of the Screening phase of the Capital Investment Process
Ethics, Strategic fit and payback are used to eliminate projects
Summary of the Definition phase of the Capital Investment Process
The collection of more detailed information, usually technical or financial
Summary of the Evaluation phase of the Capital Investment Process
Use of formalised selection criteria e.g. Payback, ARR, NPV, IRR
Summary of the Approval phase of the Capital Investment Process
Conclusion of the evaluation is endorsed usually and is transmitted through the hierarchy to relevant people.
Things to consider in the selection of an investment
- Security
- Liquidity
- Return
- Growth Prospects
- Spreading Risk
Steps of the Financial Evaluation Process
Stage 1: Determine Investment funds available
Stage 2: Identify profitable project opportunities
Stage 3: Refine and classify proposed projects
Stage 4: Evaluate the proposed project or projects
Stage 5: Approve the Projects
Stage 6: Monitor and Control the Project
What is CAPM
The return you require for the risk you are taking
Traditional Methods Of Investment Appraisal
Accounting Rate of Return (ARR)
Payback
Discounted Cashflow Methods of Investment Appraisal
Net Present Value (NPV)
Internal Rate of Return (IRR)
4 Methods of Capital Investment Appraisal
- Accounting Rate of Return
- Payback
- Net Present Value
- Internal Rate of Return
ROIC calculation
Net Operating Profit minus adjusted taxes divided by invested capital (equity and debt)
Pike (1988, 1996) Findings on the use of Capital Investment Appraisal
- Payback used the most and often used as a screening process
- ARR was used the least
- IRR is the 2nd most popular method followed by NPV
Arnold and Hatzopoulos (2000) Findings on Capital Investment Appraisal
- Payback is widely used
- IRR is as popular as NPV
- ARR is used the least
- 72% of small firms used 3 or more methods
- Smaller firms rely less on sophisticated techniques
Summary of findings from surveys on Capital Investment Appraisal
- Businesses tend to use more than one method
- NPV and IRR have become more popular
- Payback and ARR continue to be popular
- Large businesses rely more on NPV than IRR compared to smaller businesses
ARR meaning
Accounting Rate of Return
Two methods of Accounting Rate of Return (ARR)
Physical Investment (Property and Equipment):
Average annual profits / average investment x 100
Financial Investments:
Average annual profits / initial investment x 100
Making a decision with ARR Rules
For the project to be considered it must achieve a minimum target ARR
Where competing projects exceeds the minimum rate, the one with the highest ARR should be selected
Advantages of ARR
- Percentages are easy to compare
- ARR measures profitability - useful to shareholders to evaluate managerial performance
Disadvantages of ARR
- Terminology is ambiguous
- It does not account for investment scale, e.g. a 20% return on 1000 is better than a 40% return on 100
- Ignores Cash flows
- Ignores value of money
Payback Period (PP) meaning
Time takes for initial investment to be repaid out of projects net cash inflows
What does Payback Period (PP) do?
Measures length of time it takes the cash inflows from a capital investment project to equal the cash outflows
What are the rules when using Payback Period
- Project should have a shorter payback period than required maximum
- If competing projects have payback periods shorter than the max, one with shortest PP is used
Advantages of Payback
- Simple to calculate and understand
- Shows which projects repay themselves the fastest, favours low risk projects
- Good where future is uncertain
- No need to forecast cashflow
- Often in firms capital is rationed, payback is useful in these cases
Disadvantages of Payback
- Payback is ambiguous, may not be clear if firms have included working capital or not
- Ignored cash flows arising after PP
- Payback Fails to allow for ‘real time value of money’
Factors influencing the returns of a project
- Inflation
- Risk premium
- Interest foregone
Time Value of Money
Money in the future is not the same as money raised today
Compound Interest Formula
Sum x (1 + % return) to the power of x years or the periods in which you receive interest
Present Value
The value used to compare a future sum of money with todays capital cost
Present Value Formula
Amount / (1 + Interest in Decimal Form) to the power N for number of years
X / (1 + 0.Y) to power N
Future Value OVER (1+r)^n
Present Value Example: $1,000 to be received in 3 years, 5% compound interest
1,000/(1+0.05)^3
= 863.84
Future Value Formula
Amount x (1 + Interest in Decimal Form) to the power number of years
Future Value Example: $900 to be received in 3 years, 5% compound interest
900 x (1+0.05)^3 = 1041.86
Difference between Present Value Formula and Future Value Formula
Present Value you divide
Future Value you times
Net Present Value Steps
- Determine Discount (Hurdle Rate) using WACC if needed
- Calculate Using this Rate
Net Present Value Example: 900 invested, 600 from equity at 8%, 300 from debt at 6%
Outflow of 900 Yr1
Inflow of 720 in Yr2
500 in Yr3
WACC = (600/900x8) + (300/900x6) = 7.33%
Add Risk Premium (personal view of risk) say 1.67%
That makes minimum hurdle rate 9%
Yr2:
720/1.09^2 = 606.00
Yr3:
500/1.09^3 = 386.09
900 - 606 - 386.09=
NPV = -92.09
NPV Decision Rules
If Projects NPV is positive, it should be accepted, and vice versa
If competing projects have positive NPVs, highest selected
Advantages of NPV over ARR and PP
NPV Addresses:
- Timing of Cashflows
- The whole of relevant cashflows
- The objectives of the business
Calculating NPV using Discount Factor
1 OVER (1+r)^n
Times that by Cash inflow for the year
What are the two methods of calculating NPV
Formula:
Present Value =
Future Value OVER (1+r)^n
Using Discount Tables: 1 OVER (1+r)^n
What is NPV Dependant on?
- The Cashflow Forecast - Based on assumptions, if the cashflow is different so too will the real NPV be
- The Discount Rate Used
What assessment might be made to Consider the Impact of Changes in Cashflow
- Sensitivity analysis
- Scenario Analysis
A Positive and negative NPV represents
Positive means project should go ahead
Negative means the opposite
Can a project have a positive and negative NPV
Yes, the calculated NPV is based on assumptions and what actually happens is different as it is vulnerable to changes e.g. bank increases interest rates
Internal Rate of Return (IRR)
To some degree the Break Even Discount Rate, Represent the Discount rate that, when applied to future projects cash flow, produces a NPV of Zero
The rate that will discount that cashflow forecast to 0
Internal Rate of Return (IRR) Formula
Very hard to calculate unless using Excel, so, use excel
Lower Discount Rate + (Higher DR - Lower DR) x (NPV / LNPV - HNPV)
IRR Decision Rules
- Project must meet a minimum IRR Requirement (Opportunity cost of Finance)
- If competing projects exceed minimum IRR Requirements, highest IRR selected
Advantages of NPV
- Accounts for time value of money
- Guarantees most profitable project is chosen
- Accounts for investment size
Disadvantages of NPV
- Can be complex with longer projects
- Choice of discount rate is crucial and it isn’t always clear which rate to use
Advantages of IRR
- Takes into account the time value of money
- As a percentage measure it’s easy to interpret and compare
Disadvantages of IRR
- Surveys suggest it is often confused with ARR
- IRR ignores the scale of an investment project
- In certain cases, projects have more than one IRR
Mutually Exclusive Projects
When a firm can do one project or another but not both
When using an IRR and a NPV value which should you go by
The one with the higher NPV, even if IRR is lower
IRR Personal Notes
Include ‘‘Year 0’’ figures (Outflow) - caused confusion to begin with
