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Investment and Appraisal

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					     Investment Appraisal
    Geoff Leese Sept 1999 revised
    Sept 2001, Jan 2003, Jan 2006,
    Jan 2007, Jan 2008, Dec 2008
    (special thanks to Geoff Leese)

1
    Investment Appraisal

     Capital Investment is crucial for long
      term survival, to give benefit over a
      number of years
     On the balance sheet, this consists of
      fixed and current assets and current
      liabilities
     Can be seen as on-going projects
      generating return and cash flow

2
    Categories of Capital
    Investment

       Replacement of existing facilities
           Relatively low risk
       Expansion of existing facilities
           Low risk, reliable estimating in familiar markets
       New Project
           Risk increasing, unknown market or product
       Research and development
           Highly uncertain outcomes in new areas
       Welfare projects
           Required by legislation, benefits hard to measure
3
    Context and Control

       Strategic planning
           Long term objectives
       Management control
           Use of annual or longer plan cycles
           Capital budgeting techniques to plan best
            allocation and use of current resources to achieve
            aims
       Operational control
           Short term routines

4
    Appraisal techniques
       Payback Period
           Time taken for original cost to be recovered in
            cash flows
       Accounting rate of return ARR
           % return achieved over project life (differing
            definitions)
       Net present value NPV
           initial cost of project with future generated
            discounted cash flow
       Internal rate of return IRR
           % return from project over lifetime in discounted
            cash flows
5
    Opportunity cost

       When resources are limited, the benefit or
        income that is foregone as a result of a
        decision
       Example: Not spending on new machinery,
        but updating the software. Opportunity cost
        of the software is the benefit from the new
        machinery
       Such costs are not recorded in accounts, but
        very important in cost benefit analysis

6
    Payback
       Simple measure of the number of years that it will
        take to recover your original investment from net
        cash flows that result
       For example, a small, internal IS program to save
        costs:
       Original investment      £450
           net cash inflows
            –   Year 1         £100   running total cash flow   £100
            –   Year 2         £200                             £300
            –   Year 3         £100                             £400
            –   Year 4         £100                             £500
            –   Year 5         £220                             £720
       Payback 3.5 years

7
    Time Value of Money

       Preference for money to be received earlier
        and paid later
       Worth more than similar amount received
        later, as earlier monies can be invested to
        earn interest over the receiving period
       Similarly, cash paid later is worth less than
        similar sum paid earlier, as you can have the
        investment benefit for longer


8
    Judging Payback
       Reasonable to assume that stakeholders prefer
        shorter pay back periods
       But also need to consider post payback cash flows.
        How profitable will they be?
       Does not consider profitability of the project as a
        whole
       Pay back is unlike traditional accounting of profit and
        capital employed
       Very simple to use
       But ignores opportunity cost of amount of money
        initially may vary with that received between years
       And does not consider time value of money

9
 Accounting Rate of Return
 ARR
        Profits from the project are compared with the
         investment
        Future profit flow considered, also depreciation
        Compares average profit per annum, before interest
         and taxation with original cost
        Variants use profit after interest and taxation and
         other measures
        All methods acceptable, but need to ensure
         comparisons are of the same method
        Complements ROCE by relating profits to initial
         capital investment
        Does not consider time value of money

10
 ARR
        Original investment      £450, Life of asset 5 years
        Assume no residual value and straight-line depreciation
         charge of £90 (no residual value)
                    Net cash in            depreciation   profit
          – Year 1        £100            £90             £ 10
          – Year 2        £200            £90             £110

          – Year 3        £100            £90             £ 10

          – Year 4        £100            £90             £ 10
          – Year 5        £220            £90             £130
        Average profit £54 per annum
        ARR as annual average profit flow/original cost = 12%



11
 Future value of money

     This is the compound interest formula which
       tells you the future value of what you are
       currently investing

     An = P(1 + i)n

     An = future amount invested in year n
     P = amount invested now, at time n = 0
     i = interest rate
     n = number of years money is invested
12
 Rearranging for Investment
 Appraisal

     Future forecast cash flows need to be
      calculated in terms of today’s value.
      This is the opposite of compounding,
      known as discounting, seen by
      rearranging the compound interest
      formula

     P = An / (1 + i)n

13
 Net present value NPV

        Covers discounting and weighted average
         cost of funds
        Difference between the present values of
         cash inflows and present value of cash
         outflows
        If NPV positive, required rate of return likely,
         accept
        If NPV zero, consider accepting if risk also
         acceptable
        If NPV negative, project should be rejected
14
 NPV calculation Example
 Back to our example of a £450 IS investment
 Payback period 3.5 years, ARR 12%
 If opportunity cost happened to be 10% (that is we could
     have obtained 10% on another use of our money),
     estimated cash flows £ per year at present values are:
 90.9 + 165.3 + 75.1 + 68.3 + 136.6 = £536.2 total over 5
     years
 NPV = £536.2 - £450 = £86.2

 The project gives 10% return, plus a surplus of £86.2
 Go ahead

 Try this for 20% opportunity cost
15
 Internal Rate of Return

     Known as discounted cash flow (DCF) yield
     IRR is another rearrangement of the equation
     It is the interest rate that gives NPV = 0 when
         applied to the projected cash flow
     Our IS example, where r = IRR:
     0 = -P +100/(1+r)+200/(1+r)2 +100/(1+r)3
         +100/(1+r)4 +220/(1+r)5



16
 IRR

        Find the discount rate which produces an
         NPV of zero
        Do this by interpolation, graphing known
         values of NPV, trial and error or using Excel
         or financial software
        If the discount rate is greater than the cost of
         capital – acceptable
        If the discount rate is less than the cost of
         capital - reject

17
 Investigation

      Look at Excel
      Practice using NPV and IRR with the
       data we have used
      Look at the help function, and practice
       with that data

        You can use other spreadsheet, or
         Sage or other financial packages

18
 Which technique

      Many large organisations use more
       than one, as each analyses and gives
       different information
      Payback measures time capital at risk
      ARR measures profitability
      NPV and ARR both show stakeholder
       returns

19
 Cost Benefit Analysis

      Much broader view than cash or profit
       based analysis, which are purely based
       on economics
      Seeks to assess the economic and
       social advantages (benefits) and
       disadvantages (costs) of a project, then
       quantifies in monetary terms
      Major importance in public sector


20
 Assessing social benefits

      Not all easy to translate into monetary
       terms
      Broad view of stakeholders may be
       necessary, such as society as a whole
      Costs and benefits arise at different
       times
      Which discount rate to use?
      Specialist area, under much debate

21
 Audit of capital investments

        Good practice - any capital project investment
         should be assessed when it has been
         commissioned and running for a while
        Gives a feedback loop for project appraisal
         and selection, ensuring an improvement of
         the process by performing three functions:
            Improving the quality of investment decisions
             under consideration
            Improving the quality of future investment
             decisions
            Assist corrective action for current projects
22
 Further Reading

        Dyson Chapter 19




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