Lecture Four

Capital Investment Decisions

Learning Outcomes
By the end of the lecture you should be able to : Explain the concept on net present value (NPV) and internal rate of return (IRR); Calculate NPV, IRR, payback period and accounting rate of return; Justify the superiority of NPV over IRR; Explain the limitations of payback and accounting rate of return methods; Evaluate mutually exclusive projects with unequal lives; Explain capital rationing and the optimum combination of investments when capital is rationed for a period.

Assessing alternative investment opportunities. Investment Appraisal

Essentially, investment appraisal is the same as decision making.

The only difference really is probably that we look at decisions that affect now in decision making and we look at decision that will affect the next few years in investment appraisal. Investment appraisal is about looking at decisions that are going to give money back over time. if relating to cost choose proposal

We can use investment appraisal techniques to judge between choices and whether to do something or do nothing. Remember, doing nothing can be a valid choice

Essential features of investment appraisal decisions

Often very large amount of resources involved. 500k+ large buildings bridges etc. Often difficult or very expensive to get out once the decision has been made.

Usually over an extended period so the timing of money flows is important

Payback Period
Main methods of investment appraisal Illustration data: Cost now of asset Cash inflow 1 years time Cash inflow 2 years time Cash inflow 3 years time Cash inflow 4 years time Cash inflow 5 years time Disposal proceeds of asset sale

100,000 20,000 40,000 60,000 60,000 20,000 20,000

Payback period the length of time it takes to repay the initial investment out of the cash inflows.
How long does it take to payback the investment?

Payback Period
Year Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 Year 5 Payback lies between years 2 and 3 Yr 2 = (40,000) ; Yr 3 = 20,000; Movement = +60,000 in 12 months Inflow Cumulative cash flow (100,000) (80,000) (40,000) 20,000 80,000 100,000 120,000

20,000 40,000 60,000 60,000 20,000 20,000

Need movement of 40,000 = 40,000/60,000 x 12 months = 8 months

Therefore payback = 2 years + 8 months = 2 years 8 months.

Payback Period

Advantages: Disadvantages:

Accounting Rate of Return (ARR)

ARR = Average annual profit x 100 Average investment to earn that profit
Total Profits / Years (Initial Investment + Disposal Proceeds) / 2

ARR =

= (Inflows (200,000) + Proceeds (20,000) Investment (100,000)) / 5 ( 100,000 + 20,000) / 2 = (120,000) / 5 60,000 = 24,000 = 40% 60,000 initial investment + disposal value 2

Average investment =

Note the plus disposal proceeds ARR =

This gives us a percentage return that can be compared between projects or to a minimum required.

Important: You need to calculate the annual average profit and the average investment for ARR. Note it is profit not cashflow, so you may need to make an adjustment for depreciation in a question

Advantages:

Disadvantages:

Net Present Value (NPV)

A method that takes into account the time value of money. NPV reflects the value in todays terms of future cash flows. Cost of Capital of 20%.
Year Cost now of asset Cash inflow 1 years time Cash inflow 2 years time Cash inflow 3 years time Cash inflow 4 years time Cash inflow 5 years time Disposal proceeds of asset sale 0 1 2 3 4 5 5 Cashflow -100,000 20,000 40,000 60,000 60,000 20,000 20,000 20% 1.000 0.833 0.694 0.579 0.482 0.402 0.402 NPV (100,000) 16,660 27,760 34,740 28,920 8,040 8,040 24,160

Positive NPVs enhance shareholders wealth so accept. Negative NPVs reduce shareholders wealth so reject. The one with the biggest NPV is the best one to adopt.

Net Present Value (NPV)

Advantages The big advantage of NPV over ARR or Payback period is that it does take into account the time value of money. It also takes into account all of the cash flows over the whole project.

Disadvantages The only real problem is choosing the right rate to discount at. It may vary from project to project or a company may apply the same rate to all projects.

Internal Rate of Return (IRR)

A development of the NPV method. Essentially, it is only another way of looking at the problem. With NPV you choose the discount rate and then see if it makes a positive cash flow at that rate. With IRR you find out the discount rate at which the cash inflows equal the investment. The IRR is the discount rate which, when applied to the future cash flows, will make them equal the initial outlay (cost). Choose a discount rate (that you think will be higher) and one that you think will be lower. Calculate the NPV using both. One will be positive, one will be negative. Calculate the rate at which the NPV will be zero from these. Could use trial and error (iteration). Could put it on a graph. Could work it out mathematically.

Internal Rate of Return (IRR)

We already have the data with a cost of capital of 20%; we have just calculated it. Lets use a Cost of Capital of 30% as our other calculation
Year Cost now of asset Cash inflow 1 years time Cash inflow 2 years time Cash inflow 3 years time Cash inflow 4 years time Cash inflow 5 years time Disposal proceeds of asset sale 0 1 2 3 4 5 5 Cashflow -100,000 20,000 40,000 60,000 60,000 20,000 20,000 30% 1.000 0.769 0.592 0.455 0.350 0.269 0.269 NPV (100,000) 15,380 23,680 27,300 21,000 5,380 5,380 (1,880)

Calculating the IRR.

Change from previous NPV = + 24,160 to (-1,880) = 26,040 for change of 10% increase of discount rate Therefore change for 1% = 26,040 / 10 = 2,604 So to get to zero from 24,160 need 24,160 / 2,604 = 9.28% increase in rate Therefore new rate = IRR = 20% + 9.28% = 29.28% Alternatively Reduction of rate by 1,880 / 2,604 = 0.72% will again give IRR = 30% - 0.72%

= 29.28%

Comparing NPV to IRR

Where projects are independent then you will get the same answer using NPV or IRR to distinguish between them. If the projects are mutually exclusive, then sometimes you can get a different answer. This is because NPV assumes that the project cash flows are invested at the cost of capital, while the IRR method assumes that the cash flows are invested at the IRR.

The hardest part of any business plan or investment decision is always predicting the future. Interest rates Inflation Availability of raw materials, energy and other resources Will the business be viable, changes in law, demand, competition, alternative products etc
What will any scrap, facilities etc. be worth at the end

The main factors that influence the selection of a discount rate are:

Inflation What we could earn elsewhere Level of risk

If we wanted to put our money somewhere without any risk we would invest it with the Government, for example Treasury Bonds with a rate of return of, for example, 4%. If we assumed inflation of 1% then this would give us a real risk free return of 3%. Anything we do then which has a risk attached to it will mean we will want to get more than 4%. For example the average rate of return on equities recently (in more normal times) has been 8%. If you deduct the risk free rate represented by Treasury Bonds you get 4%.

Clearly, the additional 4% is the level of additional rate of return that is required to compensate for the level of risk inherent in investing in the stock market. Not every investment carries the same level of risk as investing in equities. For example, Property is considered to be half as risky as the stock market. You would only then need half the risk premium over the Treasury Bond rate, here that would be an additional 2%. So you would use a discount rate of 4+2 = 6%. Allowing for inflation at 1% this would give you a real rate of return of 5%. (Obviously these figures change with varying economic circumstances).

Problems can arise in a number of situations where you are calculating the NPV.
If a project has a positive NPV at the companys cost of capital then it can be done. If you can do every project with a positive NPV, which one will you do? Usually though, the company doesnt have money to follow up every good idea that managers have, it can only do a few. This is a situation usually described as being where there is . In this case it will usually choose the ones with the highest NPV

What if the projects are of a different size? Clearly, a project with an NPV of 80,000 looks much better than one with an NPV of 50,000 and it would be the right choice if the two projects required the same capital investments. But what if they required different investments. Example in Drury p 508 (5th edition p 470).
Initial investment Project C Project D 50,000 100,000 Present Net Present value of Value inflows 100,000 180,000 50,000 80,000

How do we choose between them?

We compare the Present Value (that is the value in todays terms of the cash inflows) to the Investment made to earn those monies. Note it is the Present Value, not the Net Present Value.

Profitability Index = Present Value of inflows / Initial Investment Project C 100,000 = 2 50,000 180,000 = 1.8 100,000

Project D

Usually a company would have far more than two projects to consider between. The process would be to rank them in order of NPV if there was no capital rationing. If there were a restriction on the availability of capital then the projects would be by index. The company would then start with the projects with the profitability index, doing as many as the available capital would allow. This may mean that we dont use all the capital available in the period.

What do we do when projects are of unequal lengths?

When you are considering between projects that dont run for the same length of time you have to consider what would happen when the shorter project finishes. There is an example (14.1) in Drury on page 336 (7th edition.). Bothnia is choosing between two machines, X and Y. They are designed differently, but have the same capacity and do the same job. The significant difference is that X costs 1.2 million and lasts three years and Y costs 600,000 and lasts only two years. To make the comparison harder, X costs 240,000 p.a. to run and Y costs 360,000 p.a. to run.

With a cost of capital of 10%, which machine should Bothnia choose to buy?
We can initially look at the cash flows. In this case, they are all cash outflows. Machine Year 0 Year 1 Year 2 Year 3 PV at 10%

X Y

(1,200) (600)

(240) (360)

(240) (360)

(240) -

(1,796.832) (1,224.78)

On the face of it, the PV of costs is lower for Machine Y so it should be chosen. Unfortunately, it means we wont be doing any work in Year Three unless we buy another machine then.

How can we take this mismatch into account? There are three main methods: Evaluate the two over a period equal to the lives. Calculate an . Estimate a

of the two

Lowest common multiple method

You look for a number of years where both machines will need to be replaced at the end of the period.

When one lasts for two years and the other for three, then the lowest common multiple method would be to work out the costs over six years. At the end of the six years, two Machine Xs would have been bought and three Machine Ys would have been bought and we would be about to buy a new one of each.
Machine Year 0 Year 1 (240) Year 2 (240) Year 3 (240) (1200) (360) Year 4 (240) Year 5 (240) Year 6 (240) PV at 10% (3,146.76)

X - Cash Outflow Investment (1200) Y - Cash Outflow Investment (600)

(360)

(360) (600)

(360) (600)

(360)

(360)

(3,073.44)

We can see that it is cheaper to buy Machine Y even though we will have to buy three of them If we are going to buy a new machine at Year 6 we could choose Machine Y, but whether we do or not will depend on how long we are going to need machines for in the future. Doing this method can be tedious, especially if the lowest common multiple is a lot of years (7 years and 3 years = 21 years). In that case we may prefer the next method.

Equivalent Annual Cost Method

We make the costs of the two machines comparable by converting them into an equivalent annuity.

Machine X present value is (1,796.832) for three years (from our earlier calculation) and for machine Y is (1224.74). X Factor PV Y Factor PV (1,200) 1.000 (1,200) (600) 1.000 (600.00) (240) 0.9080 (218.16) (360) 0.9080 (327.24) (240) 0.8264 (198.33) (360) 0.8264 (297.50) (240) 0.7513 (180.31) 2.4868 (1,796.8) 1.7354 (1,224.74)

Equivalent annual cost

Present Value of costs Annuity factor for N years at R%

The annuity factor is obtained from annuity tables (also called cumulative discount tables) for the number of years (3 in this case) and at the appropriate discount factor (10% in this case).

Equivalent annual cost for Machine X (1,796.832) 2.4869 = (722.519)

If there isnt an annuity table to hand, you can calculate it from an NPV table. 1 2 3 = = = = 0.9091 0.8264 0.7513 2.4868

N.B.DO NOT INCLUDE 1.000 for Year 0

Equivalent annual cost for Machine Y. (1,224.780) 1.7355 = (705.722) Cost at the end of year 1 year; 2; year 3 ; etc.

Which machine should we buy?

Y cheaper equivalent cost p.a. of 705.722

Estimate Terminal Values

If we had a machine that lasted eight years and one that lasted six years we would have to do a lowest common multiple calculation over 24 years. This wouldnt be much good if we only wanted the machines for a job that lasted 10 years as it is shorter. This stops us using either of the previous two methods. Both machines will need to be replaced if we worked for 10 years. So we assume we are going to replace each and attempt to determine what their disposal values will be at Year 10 when one machine is two years old and the other is four years old and we take these estimates into account as cash inflows in Year 10