Lecture Notes - Investment Appraisal

CORPORATE FINANCE

INVESTMENT APPRAISALS

Most businesses spent money on new fixed assets and spending on fixed assets is capital expenditure. Capital investment involves expenditure on fixed assets for use in project that provides returns by the way of the following

-          Interest

-          Dividends

-          Capital appreciation. (FTC Foulks Lynch 2005)

REASONS FOR CAPITAL EXPENDITURE

There are various reason why capital expenditure might be desirable and these cab be categorized into the following types (FTC Foulks Lynch 2005)

Maintenance

This is spending on new assets to replace worn-out assets or obsoletes. This could also be spending on existing fixed assets to improve safety and security features.

Profitability

This is spending on new assets to improve profitability of existing business, to achieve cost savings, quality improvement and improved productivity

Expansion   

This is spending to expand the business, to make new products, open new outlets, and invest research and development. (FTC Foulks Lynch 2005)

                           

DISCOUNTED CASH FLOW (DCF)

This is an investment appraisal technique that takes into account both timing of cash flow and also total cash flows over the project’s life. This is based on future cash flows and not accounting profit.

The timing of cash flows is taken into account by discounting them to a ‘present value’ (FTC Foulks Lynch 2002)

DISCOUNT FACTORS AND DISCOUNT TABLE.

A present value for a future cash flow is calculated by multiplying the future cash flow by a factor.

1/ 1 +r ⁿ

Example

1/1.10 = 0.909

1/1.10 ² = 0.826

1/1.10 ³ = 0.751

NB. To calculate a present value for cash flows you multiply the future cash flow by the appropriate discount factor.

Any cash flows that take place “now” (at the start of the project) take place in the year 0. The discount factor for year 0 is 1.0 regardless of what cost of capital is.

NET PRESENT VALUE METHOD (NPV)

NPV is the value obtained by discounting all cash outflows and inflows at the cost of capital. It’s the sum of the present value (PV) of all the cash inflows from a project minus the PV of all cash out flows.

The sum of the present value of all the cash flows from the project is the “Net” present value amount.  The NPV is the sum of the present value (PV) of all the cash inflows from project minus the PV of all cash outflows.

Example one

Rug Limited is considering a capital investment in new equipment. The estimated cash flows are as follows

          Year                      cash flow

                                      $

0                                             (240,000)

1                                             80,000

2                                             120,000

3                                             70,000

4                                             40,000

5                                             20,000                          

The company’s cost of capital is 9%. Calculate the NPV of the Project to assess whether it should be undertaken

Solution

Year                      Discount factor at 9%

1                                             0.917

2                                             0.842

3                                             0.772

4                                             0.708

5                                             0.650

Year            cash flow     discount factor at 9%     Present Value ($) 

                         $                                                                 $

0                 (240,000)              1.000                             (240,000)

1                    80,000               0.917                                73,360

2                 120,000                0.842                             101,040

3                   70,000                0.772                                54,040

4                   40,000                0.708                                28,320

5                    20,000               0.650                                13,000

Net present Value                                                             +29,760

The PV of cash inflows exceeds the PV of cash outflows by $ 29,760. It should therefore be under taken (FTC Foulks Lynch 2002)

Example two

Two projects A and B are under consideration. Either A or B but not both may be accepted. The relevant discount rate is 10%

You are required to recommend A or B by:

Discounting each cash flow separately and calculating the NPVs for both projects

The cash flow is as follows

Time                    Project A                         Project B

                             GHC                               GHC           

0                           (1500)                             (2500)        

1                           500                                500            

2                           600                                800            

3                           700                                1100          

4                           500                                1100          

5                           Nil                                  500            

                                                                                     

Solution

Time  PV factor              Project A                         Project B

                             GHC            GHC            GHC            GHC

          At 10%        Cash flow    PV               Cash flow    PV    

0        1.000          (1500)         (1500)         (2500)         (2500)

1        0.909          500             455             500             455

2        0.826          600             496             800             661

3        0.751          700             526             1100           826

4        0.683          500             341             1100           683

5        0.621          Nil               Nil               500             310

                                                318                                435

Exam Type Question

Pee Kay plc invests in a new machine at the beginning of year one which costs GHc 15,000. It is hoped that the net cash flows over the next five years will correspond to those given in the table

Year                               Cash flows GHc

0                                                             (15000)

1                                                                  1,500

2                                                             2,750

3                                                             4,000

4                                                             5,700

5                                                             7,500

You are required to calculate

(i)           The net present value assuming a 15% cost of capital

(ii)          The net present value assuming a 10% cost of capital      

Solution

The Pee Kay cash is as follows:

Year   cash flow     discount      Present       Discount               Present

                             Factor         value           factor                    value

          GHc            (15%)          GHc            (10%)                    GHc

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

1        1,500          0.870          1,305          0.909                    1,364

2        2,750           0.756          2,079          0.826                    2,272

3        4,000          0.658          2,632          0.751                    3,004

4        5,700          0.572          3,260          0.683                    3,893

5        7,500          0.497          3,727          0.621                    4,657

                                                (1,997)                                     190

(i)           Net present value @ 15% = (GHc 1,997)

(ii)          Net present value @ 10% =  GHC 190

Risk – NPV

Risk refers to the situation where probabilities can be assigned to a range of expected outcomes arising from an investment project and the likelihood of each outcome occurring can therefore be quantified.

Uncertainty refers to the situation where probabilities cannot be assigned to expected outcomes. Investment project risk therefore increases with increasing variability of returns, while uncertainty increases with increasing project life.

The two terms are often used interchangeably in financial management, but the distinction between them is a useful one

The problem with investment appraisal is that all decisions are based on forecasts and all forecasts are subject to varying degrees of uncertainties.

Techniques for reducing risk

·         Setting a minimum payback period

·         Making prudent estimates of cash flows to assess the worst possible situation

·         Assessing both the worst possible situations to obtain a range of NPVs

·         Using sensitivity analysis to measure the ‘margin of safety’ on input data (FTC Foulks Lynch 2002)

PAY BACK METHOD OF APPRAISAL

Payback is the time that a project will take to pay back the money spent on it. It is based on expected cash flows from the project, not accounting profit. At the end of the payback period the cash inflows from a capital investment project will equal the cash outflows. (FTC Foulks Lynch 2005

)

Calculating payback for constant annual cash flow

If the expected cash inflows from a project are equal amount, the payback period is calculated simply as:

Payback period = initial payment/ annual cash flow

Example 1

An expenditure of $2 million is expected to generate cash inflows of $500,000 each year for the next seven years.

What is the payback period for the project?

Solution

Payback = 2,000,000/ 500,000 = 4 years

Example 2

A project will involve spending $1.8 million now. Annual cash flows from project will be $350,000

What would be the payback period?

Solution

Payback = $1,800,000/$350,000 = $5.1429 years

This can be stated in either of the following ways

·         Payback will be in 5.1years

·         Payback will be 5 years 2 months

Payback in years and months is calculated by multiplying and decimal fraction of a year by 12 months.

In the above example 0.1429 years = 1.7 months (0.1429x12 months), this is rounded to 2 months (FTC Foulks Lynch 2005)

Calculating payback for an uneven annual cash flow

Under this calculation annual cash flow from a project varies from year to year. It is calculated by working out the cumulative cash flow over the year of the project. Cumulative cash flow is worked out by adding each year’s cash flows on cumulative basis, to net cash flow to date for the project. (FTC Foulks Lynch 2005)

Example

A project is expected to have the following cash flows.

Year                                Cash flow

                                       $000

1                                                                             (2000)

2                                                                             500

3                                                                             500

4                                                                             400

5                                                                             600

6                                                                             300

7                                                                             200

What is the expected cash flow?

Solution

Year                               Cash flow             cumulative cash flow

                                      $000                     $000

0                                                                             (2000)              (2000)                  

1                                                                             500                  (1500)

2                                                                             500                  (1000)

3                                                                             400                  (600)

4                                                                             600                  0

5                                                                             300                  300

6                                                                             200                  500

The payback period is exactly 4 years

Payback period is not always an exact number

Example 

A project would have the following cash flows

Year                                Cash flow

                                        $000

1                                                                             (1900)

2                                                                                500

3                                                                                300

4                                                                                500

5                                                                                600

6                                                                                300

7                                                                                200

Solution

Year                            Cash flow             cumulative cash flow

                                      $000                 $000

0                                                                             (1900)              (1900)                  

1                                                                                300               (1600)

2                                                                                500               (1,100)

3                                                                                600                 (500)

4                                                                                800                  300

5                                                                                500                  800

Payback is between the end of year 3 and the end of year 4. That is during year 4. (FTC Foulks Lynch 2005)

Merits of payback

·         Simplicity – as a concept its easily understood and easily calculated

·         Payback favours project with quick returns- rapid paybacks lead to rapid returns

·         Cash flows- it uses cash flows rather than profits 

·         Payback minimises risk- the shorter the payback period the less there is that can go wrong.)

·         Rapid payback maximises liquidity

·         Payback improves investment conditions

·         Rapid payback leads to rapid company growth

Demerits of Payback

·         It ignores project returns- cash flows arising after the payback period are totally ignored.

·         Payback ignores profitability and concentrates on cash flows and liquidity.

·         Time value of money is ignored because cash flows are categorized as pre-payback or post payback

·         Payback takes into account of the effects on business profits and periodic performance of the project as evidenced in the financial statement