Investment apprasial

Investment means purchasing capital goods – such as equipment, vehicles and new buildings – and improving existing fixed assets.

Many investment decisions involve signifcant strategic issues – such as relocation of premises or the adoption of computer-assisted engineering methods.

Relatively minor investment decisions will not be analysed to the same degree of detail as more substantial decisions on capital expenditure.

Discounting future cash flows

You will realise that managers may be uncertain which project to invest in if the two methods of investment appraisal used give conficting results: if a project is estimated to pay back at the end of year 3 at an ARR of 15%, should this be preferred to an alternative project B with a payback of four years but an ARR of 17%?

Managers need another investment appraisal method, which solves this problem of trying to compare projects with different returns and payback periods.

This additional method considers both the size of cash flows and the timing of them. It does this by discounting cash flow.

If the effects of inflation are ignored, most people would rather accept a payment of $1000 today instead of a payment of $1000 in a year’s time. Which would you choose? The payment today is preferred for three reasons:

This is called taking the ‘time value of money’ into consideration. Discounting is the process of reducing the value of future cash flows to give them their value in today’s terms.

How much less is future cash worth compared to today’s money? The answer depends on the rate of interest.

Example

How much less is future cash worth compared to today’s money? The answer depends on the rate of interest. If $1000 received today can be saved at 10% interest, then it will
grow to $1100 in one year’s time. Therefore, $1100 in one year’s time has the same value as $1000 today at 10% interest. This value of $1000 is called the present value of $1100 received in one year’s time.

Discounting calculates the present values of future cash fows
so that investment projects can be compared with each other by considering today’s value of their returns.

Discounting – how is it done?

These two variables – interest rates and time – are used to calculate discount factors.

Example

To use the discount factors to obtain present values of future cash flows, multiply the appropriate discount factor by the cash flow. For example, $3000 is expected in three years’ time. The current rate of interest is 10%. The discount factor to be used is 0.75 – this means that $1 received in three years’ time is worth the same as 75 cents today. This discount factor is multiplied by $3000 and the present value is $2250.

Net present value (NPV)

This method once again uses discounted cash fows. It is calculated by subtracting the
capital cost of the investment from the total discounted cash fows. The three stages in
calculating NPV are:

Usually, businesses will choose a rate of discount that reflects the interest cost of borrowing the capital to finance the investment. Even if the finance is raised internally, the rate of interest should still be used to discount future returns. This is because of the opportunity cost of internal finance – it could be left on deposit in a bank to earn interest. An alternative approach to selecting the discount rate to be used is for a business to adopt a cut-of or criterion rate. The business would use this to discount the returns on a project and, if the net present value is positive, the investment could go ahead.

Evaluation of net present value

Net present value is a widely used technique of investment appraisal in industry, but, as it does not give an actual percentage rate of return, it is often considered together with the internal rate of return percentage, which is not an IB specification topic.

Investment appraisal techniques provide numerical data, which are important in taking decisions. However, no manager can afford to ignore other factors which cannot be expressed in a numerical form but may have a crucial bearing on a decision. These are referred to as qualitative factors and include the following:

Investment appraisal is undertaken by using quantitative techniques that assess the financial feasibility of the project.

Non-fnancial issues can also be signifcant and therefore
qualitative appraisal of a project might also be very important.

The use of such ‘intuitive’ or ‘hunch’ methods of taking investment decisions cannot be easily explained or justifed unless they turn out to be very successful.

Quantitative investment appraisal

The initial capital cost of the investment, including any installation costs

The estimated life expectancy – for how many years can returns be expected from the investment?

The residual value of the investment – at the end of their useful lives will the assets be sold, earning additional net returns?

Methods of quantitative investment appraisal include:

Payback period

Average rate of return

Forecasting cash flows in an uncertain environment

All of the techniques used to appraise investment projects require forecasts to be made of future cash fows. These fgures are referred to as net cash flows.

Forecasting cash fows is not easy and is rarely likely to
be 100% accurate

With long-term investments, forecasts several years ahead have to be made and there will be increased chances of external factors reducing the accuracy of the fgures.

Example

For instance, when appraising the construction of a new airport, forecasts of cash fows many years ahead are likely to be required. Revenue forecasts may be afected by external factors such as:

An economic recession that could reduce both business and tourist trafc through the airport.

Increases in oil prices that could make air travel more expensive than expected, again reducing revenue totals

The construction of a new high-speed rail link within the country, which might encourage some travellers to switch to this form of transport.

These future uncertainties cannot be removed from investment appraisal calculations.

The possibility of uncertain and unpredicted events making cash fow forecasts inaccurate must, however, be constantly borne in mind by managers. All investment decisions involve some risk due to this uncertainty.

Formula:
Annual forecasted net cash
flow: forecasted cash
inflow minus forecasted
cash outflows

Net present value using discounted cash fows

The forecasted net returns or net cash fows from the project – these are the expected returns from the investment minus the annual running cost.

Quantitative techniques of investment appraisal

Payback method

If a project costs $2 million and is expected to pay back $500 000 per year, the payback period will be four years.

This can then be compared with the payback on alternative
investments. It is normal to refer to ‘year 0’ as the time period in which the investment is made.

It is normal to refer to ‘year 0’ as the time period in which the investment is made. The cash fow at this time is therefore negative – shown by a bracketed for further example.

Example:

This shows the forecasted annual net cash fows
and cumulative cash fows.

This latter fgure shows the ‘running total’ of cash fows and
becomes less and less negative as further cash infows are received.

Notice that in year 3 it becomes positive – so the initial capital cost has been paid back during this year.

when during this year? If we assume that the cash fows are received evenly throughout the year (this may not be the case, of course), then payback will be at the end of the fourth month of the third year.

How do we know this? At the end of year 2, $50 000
is needed to pay back the remainder of the initial investment. A total of $150 000 is expected during year 3; $50 000 is a third of $150 000 and one-third of a year is the end of month 4.

To find out this exact month use this formula:

Managers can compare the payback period of a particular project with other alternative projects so as to put them in rank order.

Alternatively, the payback period can be compared with a ‘cut-of’ time period that the business may have decided on – for example, it may not accept any project proposal that does not pay back within five years. The uses and benefits of the payback period technique include the following:

A business may have borrowed the fnance for the investment and a long payback period will increase interest payments.

Even if the fnance was obtained internally,
the capital has an opportunity cost of other
purposes for which it could be used. The
Speedier the payback, the more quickly the
capital is made available for other projects.

The longer into the future before a project pays back the capital invested in it, the more uncertain the whole investment becomes. The changes in the external environment that could occur to make a project unprofitable are likely to be much greater over ten years than over two.

Some managers are ‘risk-averse’– they want to
reduce risk to a minimum so a quick payback
reduces uncertainties for these managers.

The payback method is often used as a quick check on the viability of a project or as a means of comparing projects. However, it is rarely used in isolation from the other investment appraisal methods.

Average rate of return may also be referred to as the accounting rate of return. If it can be shown that Project A returns, on average, 8% per year while Project B returns 12% per year, then the decision between the alternative investments will be an easier one to make.

For
simplicity, we will assume that the net cash fows equal the annual proftability.

Example:

Shows the expected cash flows from a business investment into a feet of new fuel-efficient vehicles. The inflows for years 1 to 3 are the annual cost savings made. In year 4, the expected proceeds from selling the vehicles are included.

What does this result mean? It indicates to the business that, on average over the lifespan of the investment, it can expect an annual return of 20% on its investment.

This could be compared with:

Evaluation of average rate of return

ARR is a widely used measure for appraising projects, but it is best considered together with payback results. The two results then allow consideration of both profits and cash flow timing.