1 © 2008 Thomson South-Western
MANAGEMENT OF FINANCIAL RESOURCES AND
PERFORMANCE
SESSIONS 3& 4
INVESTMENT APPRAISAL METHODS
June 10 to 24, 2013
CA. Sonali Jagath Prasad
ACA, ACMA, CGMA, B.Com.
WESTFORD SCHOOL OF MANAGEMENT
Understand how to use appraisal
methods to manage financial resources
Session –Learning Outcome
Session -Takeaways
Evaluate how to assess strategic investment
opportunities
Understand what input data or information is
relevant for the assessment
Understand the rationale and interpretation of
investment evaluation methods
Learn how to analyse investments and justify
recommendations
I. INVESTMENTS
Investment Objectives
Manufacturing Company
Investment in fixed assets :
– Sales growth through enhanced capacity
– Product diversification through launch of new products
– Replacement of old plant and machinery
– Improve process/cost efficiencies
Financial Investment
– Set up a joint venture
– Take strategic stake through new venture or an acquisition
– Deployment of surplus funds to generate income
Finance/Investment Company
Return on investment to generate profit
Risk diversification/reduction
Types of Investments
Long-term Investments
Investment in Fixed Assets
Investment in joint ventures
Market investments
– Equity Shares
– Bonds
– Mutual Funds/ Hedge Funds
Short-term Investments
Bank fixed deposits
Money market mutual funds
Concept of Risk
Risk is defined as uncertainty regarding the outcome of an event
For an investment or project, Risk can be visualised as to how
much does the returns or profits or cash flows deviate from
expected
Therefore, Risk is normally measured as the ‘standard deviation’
of actual returns from its mean or expected value
For a company, the business risk is the variability of the firm’s
earnings
An investment which is listed on the stock markets, it faces two
types of risks:
– Systematic Risk – Risk due to the whole stock market,
external to the company
– Unsystematic Risk – Risk due to factors specific to the
Company, unrelated to the markets
Concept of Return
Return is income received by an investor on an investment.
Rate of return is expressed as percentage of the principal
amount invested.
The amount of return on an investment is a function of three
things:
– Amount invested
– Length of time that amount is invested, and
– The rate of return on the investment
Rates of return are always quoted as annual rates
The formula for the annual rate of return is: Return received
for one year’s investment / Amount invested
9
What is The Time Value of
Money?
A dollar received today is worth more than a dollar received tomorrow
○ This is because a dollar received today can be invested to earn interest
○ The amount of interest earned depends on the rate of return that can be earned on the investment
Time value of money quantifies the value of a dollar through time
The Present Value is simply the
$1,000 you originally deposited.
That is the value today!
Present Value is the current value of a
future amount of money, or a series of
payments, evaluated at a given interest
rate.
Present value
What is the Present Value (PV) of the
previous problem?
11
Present Value of a Cash Flow
Stream
A cash flow stream is a finite set of payments that an investor will receive or invest over time.
The PV of the cash flow stream is equal to the sum of the present value of each of the individual cash flows in the stream.
The PV of a cash flow stream can also be found by taking the FV of the cash flow stream and discounting the lump sum at the appropriate discount rate for the appropriate number of periods.
12
Example of PV of a Cash
Flow Stream
Joe made an investment that will pay $100 the first year, $300
the second year, $500 the third year and $1000 the fourth
year. If the interest rate is ten percent, what is the present
value of this cash flow stream?
1. Draw a timeline:
0 1 2 3 4
?
$100 $300 $500 $1000
?
?
?
i = 10%
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Example of PV of a Cash
Flow Stream
2. Write out the formula using symbols:
n
PV = S [CFt / (1+r)t] t=0
OR
PV = [CF1/(1+r)1]+[CF2/(1+r)2]+[CF3/(1+r)3]+[CF4/(1+r)4]
3. Substitute the appropriate numbers:
PV = [100/(1+.1)1]+[$300/(1+.1)2]+[500/(1+.1)3]+[1000/(1.1)4]
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Example of PV of a Cash
Flow Stream
4. Solve for the present value:
PV = $90.91 + $247.93 + $375.66 + $683.01
PV = $1397.51
5. Check using a calculator:
○ Make sure to use the appropriate rate of return, number of
periods, and future value for each of the calculations. To
illustrate, for the first cash flow, you should enter FV=100, n=1,
i=10, PMT=0, PV=?. Note that you will have to do four separate
calculations.
Data Required for Investment
Evaluation
Investment in Machinery
Cash Outflow for investment
– Purchase value
– Installation cost
– In case of replacement, sale value of old equipment
Cash Inflow
– Annual cash Profit
– Adjusted for working capital increase or decreases
– Terminal salvage value
Financial Investments
– Investment cash outflow
– Annual interest/dividend
– Final market/redemption value
Discount Rate
– Cost of Capital
Key Issues
Only use relevant income and costs
Factors to consider
– Economic
– Industrial
– Firm wide inputs
Take due care in using historical performance as an indicator of
future performance
Consistently use either nominal or real earnings and expenses
Allocation of overheads should be down judiciously
Proper estimation of repairs and maintenance expenses
Capture life of project appropriately and account for salvage
value
Working capital requirements to be captured correctly, as
practicable
Cost of funding the project to take into account the firm’s cost of
capital
II. INVESTMENT EVALUATION
1. Project appraisal / Capital Budgeting
When do you use Capital
Budgeting?
When there is a limitation of capital
When decisions need to be taken on:
– Buying a new equipment
– Lease v/s purchase
– Undertaking an expansion project
– Cost reduction investment
– Decision to replace equipment now or later
– Enhance profitability
Capital budgeting process
– Identify projects
– Determine capital available
– Set-up hurdle rates or benchmarks
– Calculate project returns or profitability above threshold
– Rank projects as per selected criteria
– Select appropriate projects
How to Evaluate Capital
Investments
Payback Method
Measures the time required for a project to recover its initial cost
How to calculate Payback?
– Calculate Initial Investment and Annual Cash Inflows
– Cumulate Cash Flows
– Payback is the time taken for the cumulative cash flow to reach zero
indicating initial investment has been paid back
Rule of evaluation
– If Payback period is below hurdle period, accept the project
– If Payback period is above hurdle period, reject the project
Analysis of Payback Method
– Quick and easy to calculate
– Rough and ready indicator of risk
– However, does not consider time value of money
– Ignores cash inflow post the payback period
– Ignores cost of capital
Payback Method - Example
Estimate the Payback period for a project which calls for an initial
investment of $ 100,000 and an annual post tax cash flows of $ 30,000
for five years.
Answer:
– Roughly, payback period is between 3 and 4 years
– Accurately,
Payback Period = Beginning of gap year + (Gap to be covered) / Annual
cash flow in gap year
= 3 + 10,000 / 30,000 = 3.33 years
Net Present Value ‘NPV’
Method
NPV measures the cash flows of a project net of initial investment
– NPV = PV of Cash Inflows – Initial Investment
Rule of evaluation
– If NPV is positive, accept the project
– If NPV is negative, reject the project
What should be the discount rate that is to be used?
Overcomes some of the disadvantages of payback method:
– Considers time value of money
– Gives weightage to initial investment
Key Issues with NPV
– Gives an absolute numbers making it difficult to rank projects
NPV Method - Example
Estimate the NPV for a project which has the cash flows as per the
following table and using a discount rate of 10%
Answer:
NPV = PV of Cash Inflows – Initial Investment
= (18,182 + 28,296 + 37,566 + 40,981 + 46,569) – 100,000
= $ 72,223
Internal Rate of Return ‘IRR’
Method
Measures the rate of return of a project
Conceptually, IRR is the discount rate at which the NPV is zero
IRR can be calculated as the rate ‘r’ in the following equation
– Initial Investment = (CFt/(1+r)n)
Rule of evaluation
– If IRR is greater than hurdle rate, accept the project
– If IRR is lesser than hurdle rate, reject the project
IRR has issues which merit consideration
– Assumes intermediate cash flows are re-invested at the same rate as the
IRR
– Projects with alternating positive and negative cash flows can throw up
more than one IRR
To overcome the above issues with IRR, one can use Modified IRR
‘MIRR’
IRR Method - Example
Comparison between NPV &
IRR Methods
Accounting Return of Return
(ARR’) Method
ARR (also called Cost Benefit Method) is a ratio of the incremental net
income to the required investment.
It is calculated as follows:
Incremental annual average after tax (accounting net income) / Net initial
investment
This method uses accounting income and not cash flows
Advantage of the ARR is that it is easy to do and to understand
The disadvantages of ARR are:
– Does not incorporate the time value of money
– Focuses on operating income instead of cash flow
ARR Method - Example
How do you Rank Projects?
What if:
– NPV is higher for Project A but has lower IRR than Project B
– IRR of Project A is lower than threshold IRR but is of strategic
importance
– Two projects have positive NPV and IRRs higher than hurdle rate?
– Project A has a life of 12 years while Project B has a life of 6 years
Use concept of Profitability Index, ‘PI’ also called Benefit-Cost Ratio is
used to rank capital investment projects
PI is calculated as PV of Cash Inflows / Initial Investment
Rule of Evaluation
– Rule : If PI > 1, accept ; If PI < 1, Reject
Also useful method when there is a capital constraints
Ranking Projects - Example
The data for 3 projects are as under:
Question : If the Company had $ 175,000 to invest, which project or a
combination thereof would be undertaken?
Risk Analysis
Sensitivity Analysis
– Is a ‘What-if’ Technique
– Evaluates how the NPV, IRR, Payback change with change in
parameters such as discount rate, material costs, labor costs etc.
– Helps in planning for uncertainties
Scenario Analysis
– Uses single point estimates based on probability of scenarios of ‘best’,
‘worst’ or ‘most likely’
Simulation Analysis
– Simulation analysis computes the various outcomes if several variables
or assumptions change simultaneously.
Monte Carlo Analysis
– Based on computational algorithms which rely on random sampling
– Uses computerized simulations to generate hundreds of possible
outcomes
What should be the Hurdle
Rate?
Should be cost of capital
At times, opportunity cost/return may be used
Cost of capital is a function of:
– Capital structure and components
– Cost of each component of capital structure
– Riskiness of project
Cost of Capital is fluid and would change over time
Should you apply different hurdle rates for different type of projects?
Could there be conflicts between various funding sources?
Issues to consider
Discount Rates
– Companies typically use the weighted average cost of capital
– Could also use a desired long term rate of return
– Sometimes, opportunity cost
Project life
– Key consideration to evaluate cash flows
– Intermittent maintenance capex should be considered
– Don’t ignore salvage value at end of useful life
Initial Investment
– Consider all costs : equipment cost, shipping, commissioning
– If considering replacement, consider post tax salvage value of old
machine
Annual cash flows
– Adjusts for non cash charges, increases in working capital, tax
– All methods consider at of year cash flow for evaluation
– Ignore any intermediate funding/cash shortfalls
– Nominal or real cash flows?
Qualitative Considerations
Following qualitative factors could influence capital investment
decisions
– Lack of enough information to make capital investment decisions
– Firm may have self imposed capital rationing limits
– Loan provisions may limit borrowing and hence capital availability for
projects
– Decision makers may be risk averse
– Managers could have conflicts between taking new projects which might
affect their division performance in the near term
– Lack of sufficient qualified personnel to implement the project
Conflicts between Company
and Shareholders
2. Lease V/s purchase
Key Aspects of a Lease
Low upfront cost and regular annual cost
Ownership rests with lessor during the lease period
Post lease period, asset could be transferred to Lessee for a fee
Depreciation benefit claimed by Lessor
Off balance sheet item for Lessee
Normally, tax deductible expense for Lessee
Terms of lease would be a function of type of equipment
Typical terms include:
– Tenor which could be 5+ years
– Upfront fee which could include up to paying one instalment
– Lease interest is typically costlier than bank loans
– End of term transfer fee is nominal, could be linked to book value
Key Aspects of a Purchase
Ownership rests with the Company
Upfront cash outflow to the Company for the equipment
On balance sheet item for the Company
Depreciation benefit available to the Company
Depreciation and interest on loan taken to purchase are tax deductible
expense for the Company
Considerations for Lease v/s
Purchase Decision
Calculate Net Advantage of Leasing which compares
– Present value of cost of leasing the asset, and
– Present value of cost of owning the asset
If NAL is positive, then lease the asset
NAL is equal to
– Installed Cost of Asset
– Less : Present value of after tax lease payments (discount rate =
borrowing cost)
– Less : Present value of depreciation tax shield (discount rate =
borrowing cost)
– Add : Present value of after tax maintenance cost incurred, if
owned (discount rate = borrowing cost)
– Less : Present value of the after-tax salvage value (discount rate
= target rate of return)
Lease v/s Buy – An Example
Option to Lease or Purchase of USD 75 mn of new equipment
Lease terms
– Tenor : 5 years
– Lease rent : USD 280 per thousand
– After 5 years, transfer to Company at nominal salvage value
Purchase
– Depreciation rate : 20%
– Borrowing rate : 8%
– Target rate of return of the company : 10%
– Equipment would require annual maintenance cost of USD 2.0
million
– Tax rate : 30%
– Salvage Value = USD 5 million
Lease v/s Buy – An Example