new investment and project appraisal

8/12/2019 New Investment and Project Appraisal

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INVESTMENTAND PROJECT

APPRAISALPrepared by: Kha Pham1


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CHAPTEROBJECTIVES

The methods of project appraisal: accounting rateof return, payback and discounted cash flow

The concepts of time preference, the opportunitycost of finance and the cost of capital

Relevant cash flows

Net present value and internal rate of returnmethods

The implications of taxation and inflation indiscounted cash flow

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I. STEPSINPROJECTAPPRAISALDecision making and control cycle:

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GROUP DISCUSSION

Imagine you were Starbucks top managers. Thecorporation planned to open the second Starbuckstore in Vietnam, following their successful operationof the first one in Ho Chi Minh City.

Appraise the potentials of this project in Hanoi andDanang City and make your conclusion!

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METHODSOFPROJECTAPPRAISAL

1. The accounting rate of return: calculates theaccounting profit (rather than cash flow) that willbe earned by a project and expresses this as apercentage of the capital invested in the project

2. Payback period: Calculates the length of time aproject will take to recoup the initial investment,based on cash flows

3. Discounted cash flow (DCF):

i. Net present value method (NPV)

ii. Internal rate of return (IRR)5


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NON-FINANCIALFACTORS

Legal

Ethical

Changes to regulations

Political Quality implication

Personnel

Coherence

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II. ACCOUNTINGRATEOFRETURN

=

100

Estimated average profits = Average annual cash flows

Estimated average investment = +

2

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ARR EXAMPLE

ABC Limited is now choosing between twoalternatives of machine for the upcoming project:

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Machine A Machine B

Cost $15,000 $15,000Estimated Scrap value $3,000 $4,000

Estimated life 3 years 3 years

Estimated future cash flows

Year 1 $4,000 $5,000

Year 2 $7,000 $7,000

Year 3 $7,000 $3,500


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A ($) B ($)Total Cash flows 18,000 15,500Total depreciation 12,000 11,000Total profit after depreciation 6,000 4,500Average profit (3 years) 2,000 1,500Value of investment initially 15,000 15,000Eventual residual value 3,000 4,000

18,000 19,000Average value of investment (/2) 9,000 9,500

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ARR for:A22%B16%Machine A is preferred!


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III. PAYBACKPERIOD

Gives greater weight to cash flows generated inearlier years

The length of time required before the total cashinflows are equal to the original cash outlay

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Machine P Machine Q

Cost $10,000 $10,000

Estimated future cash flows

Year 1 $3,000 $5,000

Year 2 $4,000 $7,000

Year 3 $4,000 $3,500

Year 4 $2,000 $2,000


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IV. TIMEVALUEOFMONEY

The value of money (purchasing power) today isdifferent from the value of money in the future!

For example, a $1,000 saving in a bank gives you$1,100 in one year

The interest rate is 10%

The two amounts have the same purchasing power tothe owner who expects the 10% interest!

In other words, $1,100 is the future value of $1,000 inone year!

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V. DISCOUNTINGANDCOMPOUNDINTEREST

Simple interest: = (1 )

Compound interest: = (1 )

Discounting: Compounding in reverse

=

( 1 )

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VI. DISCOUNTEDCASHFLOW

A technique of evaluating capital investmentprojects, using discounting arithmetic to determinewhether or not they will provide a satisfactory return

Ignore Depreciation

Only deal with Cash!

Can be used in two ways

Net Present Value (NPV)

Internal Rate of Return (IRR)

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NETPRESENTVALUE(NPV)

The sum of all present value of cash flows (bothoutflow/ initial outlay and inflow) over the period ofthe project

If NPV > 0: PV of benefits > PV of cost so theproject earns higher return than the cost of capitalshould be accepted!

If NPV < 0: PV of benefits < PV of cost so theproject earns lower return than the cost of capitalshould be rejected!

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NPV EXAMPLE

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Project A

Outlay cost $15,000

Estimated future cash flowsYear 1 $4,000

Year 2 $7,000

Year 3 $7,000

Discount rate/ Cost of capital/Required rate of return

10%

Evaluate the following project


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Year Cash

flow

Present value

factor

Present value

$ 10% $

0 (15,000) 1.000 (15,000)

1 4,000 0.909 3,636

2 7000 0.826 5782

3 7000 0.751 5257

NPV (325)

16NPV < 0: Reject the project!


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DISCOUNTEDPAYBACKPERIOD

Reflect the time value of money!

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Year Cash flow Presentvalue

CumulativePV

$ $ $

0 (15,000) (15,000) (15,000)

1 4,000 3,636 (11,364)

2 7,000 5,782 (5,582)3 7,000 5,257 (325)

4 6,000 4,098 3,773


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DISCOUNTEDPAYBACKPERIOD

Discounted payback period = 3 yrs + 325/4,098

= 3.079 years

This compares with a non-discounted payback period,instead of occurring near the end of year 3, thediscounted payback period suggests that the initialoutlay can only be recouped at the beginning of year 4

If the project stops at year 3, it will not add value to thecompany!

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COSTOFCAPITAL

The appropriate discount rate to use in investmentappraisal is the companys cost of capital difficultto determine

Both shareholders and debt holders expect somesort of returns cost of financing to the company

Cost of capital = Weighted average cost of all thesources of capital that a company uses

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ANNUITIES

In DCF, annuities are an annual cash payment/receipt that is the same amount every year for anumber of year

Instead of using the normal DCF calculation, thereis a short-cut formula for annuities

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INTERNALRATEOFRETURN(IRR)

IRR is the rate of return at which NPV = 0 (or thetotal cash inflows are equal to the total cashoutflow)

There are two steps involved in IRR calculation

Calculating IRR expected from a project

Comparing IRR with cost of capital

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VIII. TAXATIONANDPROJECTAPPRAISAL

The incremental tax cash flows should be includedin the cash flows of the project for discounting toarrive at the projects NPV

When taxation is ignored in the DCF calculation,the discount rate is pre-tax rate of return

When taxation is included in the cash flows, a post-tax rate is required!

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