Investment Appraisal
• describe the various techniques and methods
for assessing and appraising investment
projects.
• use and critically appraise the methods, in
order to control capital expenditure projects
• examine the alternative ways of calculating an
appropriate discount rate in determining the
present value of money
Need to Control Capital Assets
– Organisations are usually committed to long-term assets
for an extended time, creating the potential for
• Excess capacity that creates excess costs
• Scarce capacity that creates lost opportunities
– Capital Asset Expenditure (Capex)
The amount of money committed to the acquisition of
capital assets is usually quite large
– The long-term nature of capital assets creates risk
Capital Budgeting
Capital budgeting is the collection of tools that planners use to
evaluate the desirability of acquiring long-term assets
• Five approaches are discussed here:
– Accounting rate of return
– Payback
– Net Present Value
– Internal Rate of Return
– Profitability Index
Payback Criterion
• The payback period is the number of periods
needed to recover a project’s initial
investment
• Many people consider the payback period to
be a measure of the project’s risk
– The organization has unrecovered investment
during the payback period
– The longer the payback period, the higher the risk
– Organisations compare a project’s payback period
with a target that reflects the organization’s
acceptable level of risk
Problems with Payback
• The payback criterion has two problems:
– It ignores the time value of money
– It ignores the cash outflows that occur after the
initial investment and the cash inflows that occur
after the payback period
• Some surveys show that the payback calculation is
the most used approach by organisations for capital
budgeting
– This popularity may reflect other considerations, such as
bonuses that reward managers based on current profits,
that create a preoccupation with short-run performance
Accounting Rate of Return
• Analysts compute the accounting rate of return by
dividing the profit by the average level of investment
• If the accounting rate of return exceeds the target rate
of return, then the project is acceptable
• BUT
– By averaging, it does not consider the timing of cash flows
• This method is an improvement over the payback
method in that it considers cash flows in all periods
Time Value of Money
• Time value of money (TVM) is a central concept in
capital budgeting
• Because money can earn a return:
– Its value depends on when it is received
– Using money has a cost
• The lost opportunity to invest the money in another investment
alternative
In making investment decisions, the problem is that
investment cash is paid out now, but the cash return is
received in the future
Basic Principles of DCFs
• Time Value of Money
Single most important concept: £100 today is worth more than £100 in a
year’s time
• If interest is 12% pa, then:
Year 1: 100 x (1 + 12%) = 112
Year 2: 100 x (1+12%) x (1+12%) = 125.44
Future Value
• The future value (FV) is the amount that today’s
investment will be after earning a stated periodic rate
of return for a stated number of periods
• Because investment opportunities usually extend over
multiple periods, we need to compute future value
over several periods
Present Value
• Analysts call a future cash flow’s value at time
zero its present value (PV)
• The process of computing present value is
called discounting
• FV = PV x (1 + r)n
• PV = FV/(1 + r)n
FV with Multiple Periods
An initial amount of £1.00 accumulates to £1.2763 over
five years if the annual rate of return is 5%:
Year 0
Year 1
Year 2
Year 3
Year 4
1.000
1.050
1.102
$1.157 $1.215 $1.276
This calculation assumes the following:
– Interest earned stays invested until the end of year 5
– The rate of return is constant
Year 5
Choosing a Common Date
• An investment’s cash flows must be converted to
their equivalent value at some common date in order
to make meaningful comparisons between the
project’s cash inflows and outflows
• The conventional choice is the point when the
investment is undertaken
– Analysts call this time zero, or period zero
• Therefore, conventional capital budgeting analysis
converts all future cash flows to their equivalent
value at time zero
Decay of a Present Value
• A fixed amount of cash to be received at some future
time becomes less valuable as:
– Interest rates increase
– The time period before receipt of the cash increases
• One consequence of this decay is that large benefits expected far in
the future will have relatively little current value, especially when
interest rates exceed 10%
• Arbitrarily high interest rates will result in projects
(especially long-term ones) being inappropriately
turned down
Cost of Capital
• The cost of capital is the interest rate used for discounting
future cash flows. Also known as the risk-adjusted discount
rate
• The cost of capital is the return the organisation must earn
on its investment to meet its investors’ return requirements
• The organisation’s cost of capital reflects:
– The amount and cost of debt and equity in its financial
structure
– The financial market’s perception of the financial risk of
the organization’s activities
Discount Rates - Calculations
•
In-house hurdle rate of acquirer
Just given to you, based on not-always-logical assumptions; often the
most practicable
•
Dividend growth model
Assumes that the share price of a listed firm is equal to the discounted
value of dividends – butt ignores different levels of risk in alternative
investment opportunities
•
Borrowing rate
The rate at which you obtain new funds (LIBOR
plus some bps) – but it ignores the higher rate
required by equity holders
•
WACC (Weighted Average Cost of Capital)
Weighted Average Cost of
Capital (WACC)
WACC = (Ke x MVe + Kd x MVd)/Total MV
Ke
Kd
MVe
MVd
=
=
=
=
cost of equity, expressed as a %
cost of debt, expressed as %
market value of the equity
market value of the debt
Total MV = MVe + MVd
Capital Asset Pricing Model
(CAPM)
• CAPM forms the most often used basis for calculation of the discount rate
• It derives a value for the cost of equity which can then be fed into WACC
calculation
• WACC (Weighted Average Cost of Capital): follows the intuition as it takes
the average of the cost of debt and the cost of equity, weighted by their
relative proportions
Cost of Debt
To derive the WACC we now need to calculate the cost of debt:
•
The simplest method is to take the risk free rate (from CAPM) and
add a premium to reflect the cost of incremental borrowings for the
investor. The Finance Director should have this info, alternatively,
investment banks provide the estimate
•
The cost of debt should, in theory, take into account any change of
the firm’s credit rating due to the acquisition
•
Pure theorists argues that ONLY marginal cost of debt should be
used – higher than investor’s current borrowing rates
Terminal Value
• It is the value of the cash flows that arise after the planning period chosen
for the detailed financial projections
• Terminal value may easily be much higher than the value of cash flows in
the planning period
• Terminal value is based on the financial projections for the final year of
the planning period
Terminal Value - risks
• The company is not yet fully taxed (losses brought forward, but they
eventually will expire)
• The competitors did not catch up yet, so the company enjoys abnormally
high market share
• Capex and R&D are still high, suggesting an increasing market share in the
final year which will not occur in the long term
Net Present Value (1 of 2)
• The net present value (NPV) is the sum of the
present values of a project’s cash flows
– It incorporates the time value of money
• The steps used to compute an investment’s net
present value are as follows:
– Step 1: Choose the appropriate period length to
evaluate the investment proposal
• The most common period used in practice is one year
Net Present Value (2 of 2)
– Step 2: Identify the organization’s cost of capital, and convert
it to an appropriate rate of return.
– Step 3: Identify the incremental cash flow in each period of
the project’s life
– Step 4: Compute the present value of each period’s cash flow
using the organization’s cost of capital for the discount rate
– Step 5: Sum the present values of all the periodic cash
inflows and outflows to determine net present value
– Step 6: If the project’s net present value is positive, the
project is acceptable from an economic perspective
Internal Rate of Return (1 of 2)
• The internal rate of return (IRR) is the actual
rate of return expected from an investment
• The IRR is the discount rate that makes the
investment’s net present value equal to zero
– If an investment’s NPV is positive, then its IRR
exceeds its cost of capital
– If an investment’s NPV is negative, then it’s IRR is
less than its cost of capital
Internal Rate of Return (2 of 2)
• IRR has some disadvantages:
– It assumes that a project’s intermediate cash flows can be
reinvested at the project’s IRR
• Frequently an invalid assumption
– It can create ambiguous results, particularly:
• When evaluating competing projects in situations where capital
shortages prevent the organization from investing in all positive
NPV projects
• When projects require significant outflows at different times during
their lives
• Moreover, because a project’s NPV summarizes all its financial
elements, using the IRR criterion is unnecessary when
preparing capital budgets
Discounted Cash Flows (NPV & IRR)
• Discounted Cash Flows (DCF) are generally accepted as being the primary
valuation tool
• They should be used, if possible, alongside other valuation techniques
(stock market multiples or net asset values)
• Use DCF ONLY when a sensible set of cash flow projections is available
• DCF contains a large number of assumptions: present them clearly
Profitability Index
• The profitability index is a variation of the net
present value method
• It is used to make comparisons of mutually exclusive
projects with different sizes and is computed by
dividing the present value of the cash inflows by the
present value of the cash outflows
• A profitability index of 1 or greater is required for the
project to be acceptable
Uncertainty in Cash Flows
•
•
•
•
High – Low estimates
Expected values – probabilities
Wait and see – test market – prototype
Sensitivity analysis at what level of the
various data does the project become
unviable (% change)
• What-if analysis – e.g. what if my sales are
90% of the plan.
Strategic Considerations/non-financial
considerations
• Long-term assets usually provide the following
strategic hard-to-cost benefits:
– They allow an organization to make goods or
deliver a service that competitors cannot
– They support improving product quality by
reducing the potential to make mistakes
– They help shorten the production cycle time
Post-Implementation Audits
• PIAs can provide an important discipline to
capital budgeting
• When estimates are used to support proposals,
recognising the behavioural implications is
important
• This behaviour is mitigated if people
understand that, once equipment is acquired,
the company will compare results with the
claims made in support of the equipment’s
acquisition
Investment Appraisal Conclusion
• Long term decision making
• Linked to strategy
– Similar to short term (it’s about revenues and
costs)
– Different to short term (uncertainty of outcomes)
• Basic rules - quickest payback and most
payback