1. Presentation byFCMA, FPA, MA (Economics), BScDubai, United Arab Emirates

2. Learning Objectives2 3. Background KnowledgeInvestment Refers to an outlay of funds on which management expects a return. An investment creates value for its owners when the expected returns from theinvestment exceed its cost.Capital expenditure Refers to long-term commitments of resources that provide future benefits. Spending by a business to acquire fixed assets (e.g., property, plant, equipment, machinery, vehicles), research and development, massive market campaigns, acquisition and take-over of other Cos., etc. Why invest? Businesses need to invest in order to grow. They might want to increase capacity so they can produce more. They could also look to invest to increase the efficiency of their operations. 3 4. Definition & Utility Capital Investment Appraisal (CIA) refers to thecomplete process of generating/initiating investmentproposals, evaluating, ranking and selecting the bestalternative(s) and making follow up on investment(s)made. CIA techniques aim to assess the financial feasibility ofinvestment options. CIA looks at, how an investment opportunity is worthwhileand how it fits to the company strategy and goals??? CIA is used for all types of investment from thepurchase of a new piece of machinery to a wholefactory!!! CIA allows investment managers to make an informed choiceregarding the viability and acceptability of a project.4 5. Relevant Concepts Independent investments are projects that can be acceptedor rejected regardless of the action taken on any otherinvestment, now or later. Mutually exclusive investments are projects that precludeone another, acceptance of one project means automaticrejection of the other or vice versa. There are two types of mutually exclusive and independentinvestments replacements and investments in newproduct and processes.5 6. Nature & Importance Nature Long-term rather than short-term. Large investment rather than small investment. More complicated from concerns of future cash flows and/or time value of money. Irreversible in the normal course.Importance Large amount of resources are involved that has impact onbusiness strategy, profitability, and survival. Difficult to bail out, once an investment made. The capital investments are challenging and critical to thesuccess of the company. An incorrect decision may end withthe companys closing-out from the market. Close relationship with shareholders for their approval.6 7. CIA ProcessCIA is a five steps process normally followed by the investmentmanagers in the manner given as below: Initiating, generating and gathering investments ideas. Analyzing the costs and benefits for proposed investments by: Forecasting costs and benefits for each investment. Evaluating the costs and benefits based on CIA techniques. Ranking the relative superiority of each investmentalternative based on financial performance worked out andchoosing the best investment opportunity from the given set ofopportunities. Implementing the investment alternative chosen. Making follow-up on the investment made on regular basis tosee how far this investment opportunity has been effective in thegiven framework of the company to achieve its desiredobjectives.7 8. CIA TechniquesA: Traditional Techniques1. Payback period (PB)2. Accounting Rate of Return (ARR)B: Discounted Cash Flow (DCF)/ Time Adjusted (TA) Techniques1. Net Present Value (NPV)2. Internal Rate of Return (IRR)3. Modified Internal Rate of Return (MIRR)4. Terminal Value (TV)5. Profitability Index (PI) or Benefit/Cost RatioImportant Note: These techniques provide theoretically reliable evaluation underconditions of perfect certainty. They are, nevertheless, widely used in practice in the faceof uncertainty. 8 9. CIA TechniquesNPVPBIRRARRMIRRTV PI or B/C Ratio 9 10. Non-financial FactorsCompany Goodwill, Image & Reputation You may reject an investment opportunity, as it will reflect badly on the company goodwill, image and reputation!!!!!!Company Policies, Objectives & Culture You have to check, if the investment conforms to the policies, objectives and culture of the company???? Environmental, Social, Legal & Ethical Issues Is the investment under consideration, environmentally, socially andethically acceptable and viable????? There might be legal implications forsome investment opportunities. Impact on Stakeholder Relationships What is the impact of the investment on competitors, shareholders,employees, buyers, bankers, suppliers and government institutions, etc.,???10 11. Analyzing Strategic Position for Business Growth & InvestmentBusiness Strength HighMedium LowMarket AttractivenessBuild gradually Build aggressivelyBuild aggressively High improve & invest & grow invest & grow defend Build aggressivelyBuild graduallyMediumDivest invest & grow improve & defend Build gradually LowDivestDivest improve & defend11 12. An Illustrative ModelThere are two mutually exclusive projects A and B for theconsideration of XYZ company. The data for the initialinvestments and subsequent cash inflows is given on the nextslide.Calculate: PB, ARR NPV, IRR, MIRR, TV, & PIImportant note: This is a very simple model, where initial cash outlays(net investments),project lives, total of cash inflows over the entire lives, residual values at the end of the projects,interest rates, depreciation charges and tax rates for the projects are all same. There is no furtherinvestment after the initial one for the two investing opportunities. Moreover, the projects A and Bhave continuous stream of cash inflows during the entire period related to them.12 13. Cash Flows for Projects A & BProject A: Net Cash flowsProject B: Net Cash flows in/(out) in/(out)YearFor the year AccumulatedFor the year Accumulated AED. AED.AED. AED.0(100,000)(100,000)(100,000)(100,000)1 45,000(55,000)30,000 (70,000)2 40,000(15,000)30,000 (40,000)3 35,000 20,000 44,0004,0004 50,000 70,000 66,00070,000 The depreciation charge is AED. 20,000 per annum. The residual value for both projects is the same, AED. 20,000 Interest rate is 10% per annum All cash inflows are net-off tax 13 14. 1. PB CalculationPayback period for Project A= (change in cash flow required to reach zero/total cash flow in the year) + complete years= (15,000/35,000) + 2= 0.43 + 2 years = 2.43yearsPayback period for Project B= (40,000/44,000) + 2= 0.91 + 2 years = 2.91 years Decision Rules Project A has recovered the initial investment in 2.43 year whereas Project B hasrecovered initial investment in 2.91 years. Project A has recovered initialinvestment earlier than Project B, therefore Project A is SELECTED.Important note: A variation of this technique that involves Present Values of cash inflows is knownas Discounted Payback Period. It gives exact idea of recouping of original investment to the business. 14 15. 2. ARR Calculation Process : Calculate annual profit Annual profit = net cash inflow - depreciation : Calculate average profit Average profit = total profits / number of years : Calculate average capital invested Average capital invested = (initial cost + residual value) /2 : Calculate ARR ARR = Average profit/average capital invested x 100 15 16. ARR CalculationProject AAverage profit = (25,000+20,000+15,000+10,000)/4 = 70,000/4 = 17,500Average capital invested = (100,000+20,000) /2 = 60,000ARR = 17,500/60,000 x 100 = 29%Project BAverage profit = (10,000 + 10,000 + 24,000 + 26,000)/4 = 17,500Average capital invested = (100,000 + 20,000)/2 = 60,000ARR = 17,500/60,000 x 100 = 29%Decision RulesThe Project that has higher ARR is selected. In this case both projects have sameARR. Therefore, results from other techniques shall lead us to final decision.16 17. Time Value of Money What is the difference between AED. 1 received now andAED.1 received in a years time???AED.1 received now has more value than that is received after a year!!!The factors that change the value of money over a given period of time are given as below: Interest cost Inflation Other risks to materialise the moneyFor example The annual interest rate is 10%, I lend you AED. 1 now and will get back after 1 year, how much worth of that AED.1 in a years time?? x (1+10%) = AED. 1? = AED. 0.90910% is called cost of capital; ? is called the discount factor17 18. 3. NPV Calculation The XYZ companys interest rate is 10% p.a. Discount Factors @ 10% p.a. for AED. 1 are as given below:Year 1 = 0.909Year 2 = 0.826Year 3 = 0.751Year 4 = 0.683 Formula to calculate Discount Factor @ 10% p.a. forAED. 1 is given as follows: Discount Factor = 1/(1+10%)^n18 19. NPV Working for Project ADiscountNet Cash PresentFactor forProject A flows in Value inAED.1 @AED.AED.10% p.a.Year 12 3=1x2 0(100,000) 1.000(100,000) 1 45,000 0.909 40,905 2 40,000 0.826 33,040 3 35,000 0.751 26,285 4 50,000 0.683 34,150NPV 34,380 19 20. NPV Working for Project BDiscountCash PresentFactor forProject Bflow in Value inAED. 1 @AED.AED.10% p.a.Year 12 3=1x2 0(100,000) 1.000(100,000) 1 30,000 0.909 27,270 2 30,000 0.826 24,780 3 44,000 0.751 33,044 4 66,000 0.683 45,078NPV 30,172 20 21. NPV Decision Rules 21 22. 4. IRR CalculationIRR is the discount rate which delivers a zero NPV for a given project.Project ANPV = AED. 34,380 when the discount rate is 10%NPV = ? When the discount rate is 25%Discount Factor PresentCash flowProject Afor AED. 1 @ Value in in AED. 25% p.a.AED.Year 123=1x20 (100,000)1.000(100,000)145,0000.800 36,000240,0000.640 25,600335,0000.512 17,920450,0000.410 20,500NPV (20)22 23. IRR WorkingProject BNPV = AED. 30,172 when the discount rate is 10%NPV = ? When the discount rate is 25%Cash flow in Discount Factor for Present Value inProject A AED.AED. 1 @ 25% p.a.AED.Year 1 2 3 = 1x2 0 (100,000) 1.000(100,000) 130,000 0.800 24,000 230,000 0.640 19,200 344,000 0.512 22,528 466,000 0.410 27,060NPV(7,212)23 24. IRR Decision RulesProject A: IRR = 25%Project B:Total change in NPV = 30,172 ( 7,212) = 37,384Total change in discount rate = 25% 10% = 15%IRR = 10% + 30,172/37,384 x 15% = 22%Decision ruleFor the two mutually exclusive projects A and B, following rule shall be applied:If Project As IRR>Project Bs IRR then select Project A , &If Project Bs IRR>Project As IRR then select Project BIn this case Project As IRR>Project Bs IRR, therefore, Project A is selected.24 25. 5. MIRR CalculationMIRR is used to gauge an investments attractiveness. It is employed torank alternative investments of equal size. There are mainly two problemsof IRR that are resolved by MIRR.I. IRR assumes that interim positive cash flows are re-invested at the same rate of return as that of the project that generated them. This is usually an un- realistic scenario and more likely situation is that the funds will be re- invested at a rate closer to the companys cost of capital. IRR, therefore, often gives an unduly optimistic picture of the projects being examined. Generally, for comparing projects more fairly, Weighted Average Cost of Capital (WACC) should be used for re-investing the interim cash flows.II. More than one IRR can be found for projects with alternative positive andnegative cash flows, which leads to confusion and ambiguity. MIRR findsonly one value. 25 26. MIRR FormulaMIRR can be calculated by using Excel Formula that is given as below: = MIRR(range, finance_rate, reivestment_rate)Where:Range: is the range of cells that represent a projects cash flowsFinance_rate: is the interest rate that company pays to its banksReinvestment_rate: is the rate that company expects to receive on reinvestment of cash inflows 26 27. MIRR Decision RulesCalculation According to the data given at slide 13, Cost of Capital for the Project A and B is same at10% p.a. According to the assumption used in the formula for MIRR, the minimum returnon re-invested cash inflows is equal to Cost of Capital or Weighted Average Cost of Capital(WACC) instead of IRR of the given projects.MIRR for Project A = MIRR(range, 10%, 10%) = 18.44%MIRR for Project B = MIRR(range, 10%, 10%) = 17.50%Decision Rules In case of independent projects, the project having MIRR greater than Cost of Capital is acceptable. For mutually exclusive projects, the project having higher MIRR shall beselected. Conclusion Project A has higher MIRR than that of Project B. Therefore, A should be selectedaccording to the criteria established for acceptance and rejection of projects under MIRR. 27 28. 6. Terminal Value Calculation At the end of year Expected rate of return (%) 17 29 36 4828 29. Terminal Value WorkingTotalTotal Net cashNet cashcompounded compoundedYr. RoI YuICF inflows inflows for sum forsum for Project A Project BProject AProject B12 34 56=4x5 7 8=4x7%AED. AED.AED.AED.17 31.22545,000 55,12530,00036,75029 21.18840,000 47,52030,00035,64036 11.06035,000 37,10044,00046,64048 0 - 50,000 50,00066,00066,000Total 170,000189,745 170,000185,030 Abbreviations used in the table: RoI: Rate of Interest expected from the market (minimum expected rate can be used) YuI: Years under investment CF: Compounding factor based on given rates Yr.: Year 29 30. Terminal Value ResultsNow, we can calculate the Present Value of the compounded sums forProject A and Project B in the following manner:Project A compounded sum x PV factor @ 10% = AED. 189,745 x 0.683 Present Value for Project A compounded sum = AED. 129, 596Project B compounded sum x PV factor @ 10% = AED. 185,030 x 0.683 Present Value for Project B compounded sum = AED. 126,375 Important NoteA variation of Terminal Value (TV) is based on the pattern of NPV technique and is known as NetTerminal Value (NTV) technique. Symbolically, NTV = PVTS PVO. It has the same DecisionRules that are used for NPV technique. If NTV is positive accept the project and if it is negative thenreject it. 30 31. Terminal Value Decision RulesDecision RulesFor single project, If the Present Value of the Total of compounded re-invested cash inflows (PVTS) is greater than the Present Value of the Outflows (PVO), the proposed project is accepted, otherwise not.For multiple projects (mutually exclusive projects), the project having PVTS greater than all competing projects when compared with PVOs relating to them, shall be selected.Symbolically,PVTS>PVO AcceptPVTSPVO Accept,6. TVWith the highest PVTS>PVO And if PVTS