Lecture+4+Investment+Appraisal+Mehtods+11 12 (1)

Slide 6.1

Denzil Watson and Antony Head, Corporate Finance: Principles and Practice, 5th Edition, © Pearson Education Limited 2010

56863 Managing Finance

Week 5 27/Oct/2011Dr. Chloe Yu-Hsuan Wu

Investment Appraisal Methods

Slide 6.2


• Years to recover initial investment• Example:

Year Project A Project B0 (1000) (1000)1 400 6002 400 4003 400 2004 400 nilPayback 2.5 years 2 years

Payback period

Slide 6.3


Payback period

Payback decision rule

Accept the investment which recovers the

initial cost the soonest (or within a predetermined time period

Slide 6.4


Advantages of payback period:• Simple concept to understand• Easy to calculate (provided future cash flows

have been calculated)• Uses cash, not accounting profit• Takes risk into account (in the sense that earlier

cash flows are more certain).

Payback period (Continued)

Slide 6.5


Disadvantages:• Considers cash flows within the payback period

only; says nothing about project as a whole• Ignores time value of money• Does not indicate whether the project increase

the value of a company.

Payback period (Continued)

Slide 6.6


Accounting rate of return

The accounting rate of return (or return on

capital employed) is the average annual profit

divided by the average (or initial) investment

Average annual profitsAverage investment

orAverage annual profits

Initial investment

Slide 6.7


Accounting rate of return (Continued)

• Average annual accounting profit can be calculated from project cash flows by taking off depreciation.

• Accounting profit is not cash flow.• Simple decision rule: accept project if ROCE is

equal to or greater than target value i.e. current company or division ROCE.

• If projects are mutually exclusive, select project with highest ROCE.

Slide 6.8


Example:• A machine costs £10 000• Useful economic life is 5 years• After 5 years, scrap value of £2000• Net cash inflows from the machine would

be £3000 per year• Ignore taxation.


Slide 6.9


Example:• Depreciation: (10 000 – 2000)/5 = £1600• Average annual profit: 3000 – 1600 = £1400• Average investment: (10 000 + 2000)/2 = £6000• ROCE: (1400/6000) × 100 = 23%


Slide 6.10



Advantages of return on capital employed:• Gives value in familiar percentage terms• Can be compared with primary accounting ratio,

ROCE• Relatively simple concept compared to DCF

methods such as NPV and IRR• Can compare mutually exclusive projects• Considers whole of project, unlike payback.

Slide 6.11



Disadvantages of return on capital employed• Uses accounting profit rather than cash:• Uses average profits and hence ignore timing of

profits• Ignores time value of money• Relative measure and so ignores size of initial

investment.

Slide 6.12


Why is time value important?

•uncertainty of the future• inflation•money invested now can make a profit in

the future

Slide 6.13


Net present values

Evaluates an investment by comparing the PVof future cash flows at an assumed cost ofcapital and the capital outlay of the investment

Regarded as the best investment appraisal method by academics

Decision rule:

•select the investment with a + NPV•choice of investment: select the investment

with the highest NPV

Slide 6.14


Net present value (Continued)

• NPV is given by:

C1 C2 C3 Cn

– I0 + _____ + _____ + _____ + . . .+ ____

(1+r) (1+r)2 (1+r)3 (1+r)n

Where:• I0 is the initial investment• C1, C2, . . Cn are the project cash flows occurring

in years 1, 2, . . n• r is the cost of capital or required rate of return.

Slide 6.15



Example:• Project costing £1000 is expected to yield £500

per year for 2 years. What is the NPV?Year Cash flow 10% PVF PV0 (1000) 1.000 (1000)1 500 0.909 4552 500 0.826 413

NPV = (132)

Would you accept the project? No.

Slide 6.16



Advantages:• Takes account of time value of money• Uses cash flow, not accounting profit• Takes account of all relevant cash flows over

life of project• Gives absolute measure of project value.

Slide 6.17



Disadvantages:• Project cash flows may be difficult to estimate

(but applies to all methods)• Accepting all projects with positive NPV only

possible in a perfect capital market• Cost of capital may be difficult to find• Cost of capital may change over project life,

rather than being constant.

Slide 6.18


Internal rate of return

• IRR is discount rate which gives zero NPV for project.

• Decision rule is to accept all projects with an IRR greater than company's cost of capital or target rate of return.

Slide 6.19


Internal rate of return (Continued)

Investment project

Discount rateIRR

NPV

0

–

+

Slide 6.20


Internal rate of return (Continued)

C1 C2 C3 Cn

_____ + _____ + _____ + . . .+ ____ _ I0 = 0 (1+r) (1+r)2 (1+r)3 (1+r)n

Where:• I0 is the initial investment• C1, C2, . . Cn are the project cash flows occurring

in years 1, 2, . . n• r is internal rate of return.

Slide 6.21


IRR versus NPV• If IRR is used to compare mutually exclusive

projects, wrong project may be selected: NPV always gives correct selection advice.

Discount rate

IRR of incremental project

0

–

NPV

+

Cost of capital

Project B Project A

Area of conflict

Slide 6.22


IRR versus NPV (Continued)

• A problem if applying IRR to projects with non-conventional cash flows is that multiple IRRs may be found: again, NPV gives correct selection advice.

• NPV can accommodate changes in discount rate during project, but IRR ignores them.

• NPV method assumes that cash flows can be reinvested at a rate equal to the cost of capital: IRR method assumes that cash flows can be reinvested at rate equal to IRR.

Slide 6.23


Conclusion

•NPV is academically preferred as an investment appraisal method – it has no major defects.

• IRR comes a close second and can prove to be a useful alternative.

•ARR and payback are flawed as investment appraisal methods but payback is often used as an initial screening method.

Slide 6.24


Other factors•Taxation

▫Capital allowance▫Tax relief

•Inflation▫Real value of future cash flow

•Risk and uncertainty

Slide 6.25


Reading

•Textbook : chapter 6, 7

Lecture+4+Investment+Appraisal+Mehtods+11 12 (1)

Documents

antony head

pearson education limited

corporate finance

years denzil watson

payback project

payback period years

project cash flows

years project b