CAPITAL INVESTMENT APPRAISAL

N.B. These notes are based on the capital investment appraisal questions set in many other Exams. They are not therefore necessarily comprehensive different topics could be set in the Exams.

CONTENTS
1. MEANING OF RELEVANT CASH FLOWS 2. EXAMPLES OF RELEVANT CASH FLOWS 3. ITEMS WHICH ARE NOT RELEVANT CASH FLOWS 4. CAPITAL OUTLAYS AND CASH INFLOWS 5. CASH FLOW LAYOUT 6. THE MEANING OF: PAYBACK / NET PRESENT VALUE / IRR 7. CALCULATING DISCOUNT FACTORS 8. INTERPOLATING BETWEEN TWO DISCOUNT RATES 9. NPV v IRR 10. ADVANTAGES AND DISADVANTAGES OF NPV AND IRR 11. ADVANTAGES AND DISADVANTAGES OF THE ACCOUNTING RATE OF RETURN 12. ADVANTAGES AND DISADVANTAGES OF PAYBACK 13. SENSITIVITY ANALYSIS GEOFF PAYNE MARCH 2008
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1. Meaning of relevant cash flows A relevant cash flow is one which will change as a direct result of a decision about an investment one which will occur in the future a cash flow incurred in the past is irrelevant; it is a sunk cost the difference between the cash flows 1. With the investment and 2. Without the investment Only future, incremental cash flows are relevant Why is it important to distinguish between relevant and irrelevant costs in project evaluation?

It is important to distinguish between relevant and irrelevant costs in decision making because only relevant costs should be included and all irrelevant costs should be excluded. If one fails to accurately distinguish between the two ones decision will be based on the wrong data.

2. Examples of relevant cash flows:

Future sales revenue Future production costs Initial outlay Future scrap / salvage value Working capital outlays or reductions Future taxes Opportunity costs (lost inflows caused by the project) e.g. if a decision to build on piece of land would result in the inability to realise an appreciation in the value of the land involved

3. Items which are not relevant cash flows

Changed future depreciation Depreciation is not a cash flow it is the accounting amortisation of an initial capital cost Depreciation is the result of accounting entries (journal entries) rather than a flow of cash Reallocated existing overhead costs ie the overhead costs dont change; they are merely reallocated Cost of unused idle capacity Costs incurred in the past or already committed they are sunk costs Finance flows not directly caused by the project although they may be caused by finance raised for the project e.g. Interest paid on debt Loan repayments Dividends paid on equity NB The process of discounting future cash flows enables a decision to be made as to whether the project finance costs would be sustainable to include those finance costs in the discount calculations would distort the calculations. Discounting takes the cost of financing into account automatically.

4. Capital outlays are treated as occurring in Year 0 unless otherwise indicated.

Cash inflows are treated as occurring at the end of a year.

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5. Cash flow layout Set the cash flows out in a Table This table should read across, in End of Years, starting at Year 0 (now) and ending at the projects last year The cash flow table should read down in cash flow elements Example (using 10% discount factors) Year 0 1 2 3 4 5 New machinery Old machinery - residual value Working capital Cash savings Net cash flows Discount factors Present Value Net Present Value (NPV) 6. Explain what is meant by: Payback Payback is a commonly used method of appraising capital investment projects. It is seen as a useful way of measuring the degree of risk involved in recovering the funds invested. The payback period is the time that must elapse before the net cash flows from a project result in the initial outlay result in the initial outlay being recovered in cash terms. It is argued that the shorter the payback period the more attractive the project. It is a valid indicator for capital investment appraisal although it ignores inflation. It also, perhaps more crucially, gives no indication of the overall cash flow benefits since it ignores all cash flows after payback has been achieved, even when the later cash flows result in the project never being paid back. It is for this reason that it should never be used in isolation. Net present value A project that has a net present value (NPV) of 5000 means that if the organisation undertakes the project it will be better off by 5000 IRR. (700) 50 160 160 (490) 1.0 (490) 178.6 160 0.909 145.4 160 160 0.826 132.2 160 160 0.751 120.2 160 160 0.683 109.3 100 160 260 0.621 161.46

IRR is a means of appraising a project in financial terms. It takes into account the time value of money i.e 1000 received today is worth more than 1000 received in a year's time. IRR refers to the discount rate which, when applied to the project's cash flows, causes the cash inflows to equal the cash outflows, with the result that the net present value of the project is equal to zero. If a project has an IRR of,say, 15% this means that a project will be profitable if it can be financed at a rate less than 15%. The IRR criterion is that a proposal with a return greater than the cost of capital (discount rate) can be accepted. If there is more than one option, the option with the highest IRR should be accepted.

7. Calculating discount factors Formula is 1 / (1+r)n where r is the discount rate and n = no of years So, the 10% discount rate sum is: 1 / (1 + .1)1 (= 1.1) for year 1 = 0.909 1 / (1 + .1)2 (= 1.210) for year 2 = 0.826
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8. Interpolating between two discount rates in order to arrive at the IRR Ensure that one discount rate has a positive NPV and the other has a negative NPV. Example: 8% discount rate has produced a NPV of 8427 14% discount rate has produced a NPV of -2387 Deduct 8% from 14% = 6% Calculate (8427 / (8427+2387 ) = 8427 / 10,814 =.77927 Multiply 6% by 0.77927 = 4.68% 8% + 4.68% = 12.68% = the IRR 9. NPV V IRR

NPV is considered the superior method since in relation to mutually exclusive projects:

NPVs provision of financial returns (e.g. NPVs of say 1.6M and 1.0M) tells you how much richer you would be in absolute terms and thus facilitates the choice of project to pursue - assuming profit maximisation is your goal. IRR tells you only in relative terms (e.g. 18% and 12%) which does not tell you how much richer you would be and is therefore less useful to decision makers. In the example, the 18% IRR project could generate a very modest NPV whilst the 12% IRR project could generate a very substantial NPV NPVs are easier to base a decision upon (by choosing the project which gives the higher NPV) in situations where IRR generates multiple yields that straddle the hurdle rate.

10. Advantages and disadvantages of NPV and IRR.

NET PRESENT VALUE (NPV) Advantages Easy to interpret / Accounts for investment size The result of an investment appraisal using NPV is easy to interpret. If a project generates a positive NPV (say 10,000) this means that the business will be better off by 10,000 if it accepts the project. NPV ensures that cash flows are adjusted by the cost of capital and thus ensures that it accounts for the size of investments in its recommendations Ranking mutually exclusive projects The result is expressed in financial terms making the comparison with other mutually exclusive projects easier to achieve e.g a project that has a NPV of 1.6M is preferable to (a mutually exclusive) one that has a NPV of 1.0M. Ranking ability in capital rationing situations If the capital available for investment is limited the projects can be ranked by calculating each of their NPVs relative to the capital they require enabling a choice to be made that produces the greatest returns relative to the limited funds available Realistic reinvestment assumptions NPVs assume that cash f lows can be reinvested immediately at the discount rate (cost of capital) which
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Disadvantages Sensititivity to discount rate The results are very sensitive to the rate of discount chosen and in capital rationing, where NPVs as % returns on investment are being compared, a change in discount rates can change the rankings of projects since the impact of different rates can vary materially from project to project according to the timing of the cash flows.

is a reasonable assumption. (In contrast IRR makes the less reasonable assumption that cash flows can be reinvested immediately to earn a return equal to IRR) INTERNAL RATE OF RETURN (IRR) Advantages Easy to interpret A decision as to whether or not to invest can be straightforward. If the IRR is higher than the hurdle rate (the minimum rate acceptable to the investor or the cost of capital) then the project can be accepted Disadvantages Reinvestment assumptions / Doesnt account for size IRR assumes that all investment proceeds can be reinvested to earn a return equal to the projects IRR. This is a potentially fatal flaw in IRR, particularly re: projects that earn higher than normal returns IRR does not account for investment size; a 50K project may have a slightly higher IRR than a 500K project but the 500K project will probably offer a much higher absolute return. Mutually exclusive investments IRR is not of great use in distinguishing between mutually exclusive projects. e.g. Project As IRR may be greater than Project Bs but Project A may have a substantially higher NPV than Project B. Thus, in general you should use NPV to distinguish between projects. Multiple yields IRR is capable of generating multiple yields from the same cash flows e.g. when the sequence of flows is Initial investment outflow Inflow Outflow The different IRRs generated could fall either side of the hurdle rate, complicating the investment decision

Target setting Businesses can set target IRRs for project appraisals these take the timing of earnings into account, unlike say a target accounting rate of return. Perpetual cash flows Where cash flows can be regarded as a perpetuity the IRR is simple to work out. One simply divides the annual cash flow (say 4,000) by the initial outlay (say20,000) to give the IRR of 20%

11. Advantages and disadvantages of the Accounting rate of return ACCOUNTING RATE OF RETURN (ARR) Advantages Simple to understand and calculate The formula is: Average accounting profit over the life of the project / Average capital employed Disadvantages Uses accounting profits It uses accounting profits rather than cash flows -as a result it incorporates non cash costs such as depreciation Ignores time value of money Unlike NPV and IRR, ARR (in common with Payback) ignores the time value of money and thus, for example, accounting profits earned in later years are given equal weight to those earned in earlier years Cant compare with cost of capital Because ARR is such a limited method of appraisal it is not meaningful to compare it with the cost of capital, the minimum acceptable return on capital
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12. The advantages and disadvantages of Payback PAYBACK Advantages Simple to understand and to calculate The concept that This investment pays us back in 3 years is easy to understand. It is also easy to calculate simply requiring a quick review of the cash flows to find the period in which , in total, they amount to the initial outlay. Useful way of measuring risk It is a useful way of measuring the degree of risk involved in recovering the funds invested since, arguably, the shorter the payback period the more attractive the project Disadvantages Ignores cash flows after payback Payback ignores all cash flows after payback has been achieved and hence gives no indication of the overall cash flow benefits, even when the later cash flows result in the project never being paid back. It is for this reason that Payback should never be used in isolation Ignores the pattern of cash receipts / time value of money Payback does not take into account the pattern of cash receipts within the payback period; e.g they could be front loaded - weighted towards the start of the payback period - (attractive) or back loaded- weighted towards the end of the payback period (less attractive) In other words Payback ignores the time value of money

Target period can be set As with the accounting rate of return a target payback period can be set if the payback period is shorter than this target the project is acceptable 13. Sensitivity analysis Sensitivity analysis refers to establishing how sensitive the result (e.g the NPV or IRR) is to changes in the assumptions made about the project. Sensitivity is measured by establishing how far an assumption (e.g. sales, cost levels, the discount rate etc) can change before the NPV falls to zero. If, for example, the NPV of a project is 30,000 and the NPV of the anticipated sales income is 90,000 this means that the sales income could fall by one third (30,000 / 90,000) before the project NPV becomes zero. Sensitivity is an essential part of capital investment appraisal since, without it, the organization would have no information about the risk associated with an investment. Where there is a wide margin of safety the organisation can be fairly confident. If the margin of safety is narrow more investigation may be needed and if the project still looks risky it could be rejected even though it shows a positive NPV.

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