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INVESTMENT APPRAISAL The nature of investment decisions and the appraisal process Non-discounted cash flow techniques Discounted cash flow techniques Allowing for inflation and taxation in DCF Adjusting for risk and uncertainty in investment appraisal Specific investment decisions (lease or buy; asset replacement, capital rationing)

The Nature of Investment Decisions and the Appraisal Process

What is an investment? An investment is any expenditure in the expectation of future benefits. Investments can be made in non-current assets or working capital. What are some benefits from Investing? Savings because assets used currently will no longer be used o Savings in staff cost o Saving in other operating costs Revenue benefits because of improvement / enhancements o More sales revenue o More efficient system o Savings in staff time Inflow from sale of currently in use assets Intangible benefit o Customer satisfaction o Improve staff morale o Better decision making

How can investments be categorised? Investments can be categorised into Capital Expenditure and Revenue Expenditure. What is Capital Expenditure? Capital expenditure is expenditure which results in the acquisition of non-current assets or an improvement in the earning capacity of non-current assets.

What is Revenue Expenditure? Revenue expenditure is expenditure which results in maintain the existing earning capacity of noncurrent assets. It also includes expenditure related to selling and distribution expenses, administration expenses and finance charges. What is involved in investments in Non-current Assets? Investments in Non-current Assets involve a significant elapse of time i.e. the time funds are committed to acquiring the non-current to the recoupment of the investment will be long. What is involved in investments in Working Capital? Investments in working capital involve funds invested in resources such as, inventory, before it can be recovered from sales of the finished product or service. The funds are only committed for a short period of time. How do the overriding factors in Investment decisions differ in the Commercial Sector and the Notfor-Profit Organisation? The commercial sector investment decisions are generally based on financial considerations alone whereas with not-for-profit organisations relatively few organisations capital investments are made with the intention of earning a financial return the overriding factors are social costs and social benefits of the investment. What is Capital Budgeting? Capital budgeting is the process of identify, analysing and selecting investment projects whose returns are expected to extend beyond one year. What is the Capital Budget? The capital budget contains the expenditure required to cover capital projects already underway and those it is anticipated will start in the next possibly three to five years. Note: Budget limits or constraints might be imposed internally or externally. Internal constraints are often imposed when managerial resources are limited, this known as soft capital rationing. External constraints are often imposed by external limits either because of scarcity of finance, high financing costs or restrictions on the amount of external financing, this is known as hard capital rationing. Why is the Appraisal process necessary? Capital expenditure often involves investment of substantial funds Funds can be tied up for many years

Describe the Investment decision making Process?

Origination of proposal the origination of the proposal can come either from mechanisms the entity has put in place to scan the environment for investment opportunities; technological change/developments; or those working in technical positions. Project screening each project must be subjected to detailed screening. Only if a project passes this initial screening will more detailed financial analysis begin. Analysis and acceptance this step involves carrying out financial analysis of the project and comparing that to predetermined acceptance criteria and also considering the project in light of the capital budget for the current and future operating periods. Monitoring and review this step involves project control i.e. ensuring that capital spending does not exceed the amount authorised, the implementation of the project is not delayed, and the anticipated benefits are eventually obtained.

Non-discounted Cash Flow Techniques

What are the Non-discounted Cash Techniques? Relevant Cost Payback Return on Capital Employed (ROCE)

What is Relevant Costs? Relevant costs are costs that are incurred as a result of a decision. What are some relevant costs? Opportunity cost Variable cost that vary with output (such as working capital cost) Incremental cost (such as Infrastructure and human development costs)

What are some non-relevant costs? Sunk costs Committed costs Overhead absorbed arbitrarily Non cash flow

Example BPP text Page 134

What is the Payback Method? Payback method is method that calculates the time it takes for cash inflows from a capital investment project to equal the cash outflows, usually expressed in years. What are the advantages of Payback? Easy to use, calculate, and understand It is a measure of risk since rapid payback minimises risk Useful approach for ranking projects where a company faces liquidity constraints It is useful for where future cash flows difficult to predict It uses objective cash flows rather than subjective accounting profits

What are the disadvantages of Payback? It ignores the time value of money It does not measure the Return on Investment It ignores cash flows that occur after the payback date It is unable to distinguish between projects with the same payback period It has to be used with other methods to give a fuller picture The choice of any cut-off payback period is done arbitrary

What is Return on Capital Employed? ROCE is a measure that considers the impact of the investment on accounting profit. It is calculated as the average annual profit divided by the average investment expressed as a percentage. ROCE = Estimated Average Annual Profit / Average Investment x 100 Annual investment = Capital cost + disposal value / 2 How does ROCE differ in investment appraisal and performance appraisal? In investment appraisal the time period is over the life of the project whilst in performance appraisal it is over a single year. Investment appraisal looks to future benefits while performance appraisal looks to the past. Investment appraisal is used in decision making while performance appraisal is used to reward or appraise performance. Investment appraisal = Estimated Average Annual Profit / Average investment x 100 Performance appraisal = Profit Before Interest and Tax / Capital Employed (Debt + Equity) x 100 NOTE: The investment appraisal formula is based on profits and not cash flow therefore if the cash flow is given you may have to deduct accounting expenses such as depreciation. Example: ROCE

What are the advantages of ROCE? It is easy to use, calculate, and understand It is widely accepted as reliable measure It can be calculated from available accounting data It shows the impact an investment will have on a companys profit

What are the disadvantages of ROCE? It fails to take into account the project life It fails to take into account the timing of cash flow It uses subjective accounting profit as a pose to objective cash flow It does not indicate whether to invest or not

Discounted Cash Flow Techniques

What are the two methods of Discounted Cash Flow? NPV method IRR method

What is Discounted Cash Flow? Discounted cash flow is an investment appraisal technique that takes into account both the timing of cash flows and also total profitability over a projects life. Discounted Cash Flow looks at the cash flow of a project not accounting profits. The timing of the cash flow is taken into account by discounting them. What is the Cost of Capital? The Cost of Capital is the cost of funds that a company raises or the return that investors expect to be paid for putting funds into the company. It is therefore the minimum return that a company should make from its own investments. What is the Net Present Value method? The Net Present Value method is the key appraisal techniques. It accepts projects with a positive NPV. It is the value obtained by discounting all cash outflows and inflows of a capital investment project by a chosen target of return or cost of capital. NOTE: There are three conventions concerning the timing of cash flows annuity, annuity due and perpetuity. Example: NPV

What are an Annuity, Annuity Due and Perpetuity? Annuity Cash flow assumed at the end of every year for a finite period Annuity Due Cash flow assumed at the beginning of every year for a finite period Perpetuity Cash flow assumed every year for an infinite period How would you calculate the Discount Factor for an investment that is Perpetual? For example, the PV of $X per annum in perpetuity at a discount rate of X% would be $X/X% Example BPP text Page 147 What is the Internal Rate of Return (IRR)? The IRR is the rate at which Net Present Value is equal to 0. The IRR method of investment appraisal is to accept projects whose IRR exceeds a target rate of return. How do we calculate the IRR? IRR = A + NPV (A)/ NPV (A) - NPV (B) x B-A% Step 1: Calculate the net present value using the companys cost of capital Step2: Calculate the net present value using a second discount rate Step3: Use two NPVs to estimate the IRR. What are the Advantages of IRR? It recognises the time value of money It is based on objective cash flows as a pose to subjective profits It allows for the timing of cash flows Universally accepted method Easily understood as a percentage return on investment

What are the Disadvantages of IRR? It does not indicate the size of the investment It can give conflicted signals with mutually exclusive projects It can be confused with the ARR It assumes that earning throughout the period of the investment are re-invested at the same rate of return NPV is easier to calculate than the IRR

Example: NPV vs. IRR

Allowing for Inflation and Taxation in DCF

What is Real Cash flows? Real cash flows are cash flows which have had the effects of inflation removed What are monetary cash flows? Monetary cash flows are cash flows that have not had the effect of inflation removed. They are the cash flows that actually occur the cash that is actually received or paid out. When do we use the Real rate and Money rate? If the real cash flows are being used then the rate of return must be the real rate of return i.e. the rate that excludes inflation. If the money cash flows are being used then the rate of return must be the money rate of return i.e. that is the rate that includes inflation. Note: The money rate of return is sometimes called the nominal rate What is the Fisher formula? (1+m)= (1+r) (1+i) (1+r)= (1+m)/ (1+i) Where R = real discount rate, M = money discount rate and I = inflation rate What are the Advantages and Disadvantages of using inflation? Advantages: It is realistic to anticipate that price will increase

Disadvantages: It is extremely difficult to forecast the rate of inflation

What is it that we have to make allowances for Taxation? Organisations must pay tax, and the effect of undertaking a project will be to increase or decrease tax payments each year. These incremental tax cash flows should be included in the cash flows of the project for discounting to arrive at the projects NPV. How do Taxes affect the calculations of DCF question? We have to calculate the written down allowance (WDA) The timing of tax relief can be complicated

Note: Strictly speaking year 0 is the 31st of the previous month in PV terms. For tax purposes this would be year 1 because it falls in the calendar year. Example: Taxation and DCF

Adjusting for risk and uncertainty in investment appraisal

What is the Difference between Risk and Uncertainty? Risk can be applied to a situation where there are several possible outcomes and, on the basis of past relevant experience, probabilities can be assigned to the various outcomes that could prevail. Uncertainty can be applied to a situation where there are several possible out but there is little past relevant experience to enable the probability of the possible outcomes to be predicted. What are the techniques for measuring risk? Sensitivity analysis Expected values Adjusted discount rates Payback

What is sensitivity analysis? Sensitivity analysis assesses how responsive the projects NPV is to changes in the variables used to calculate that NPV. Thus we can analyse how far variables can change before the NPV is negative. Give example of variables that can affect the NPV? Selling price Sales volume Cost of Capital Initial Costs Benefits

How can we calculate the sensitivity of each variable? Sensitivity = NPV / Present value of project variable x 100 Example BPP Page 171 What are the disadvantages of the sensitivity analysis? The method requires changes in each key variable be isolated o Management is more interested in changes in more than one variable change

o Looking at key variables in isolation is unrealistic Does not examine the probability that any particular variation in cost/revenue might change In itself it does not provide a decision rule

What are Expected Values? Expected values are used when there are a range of possible outcomes which can be identified and a probability distribution can be attached to those values. Formula for expected value = px Learn Joint Probability What are the disadvantages with expected vales? Expected NPV may never actually occur Assigning probabilities to events is highly subjective It does not evaluate a range of possible NPV

Specific Investment Decisions (Lease or Buy; Asset Replacement, Capital Rationing)

What is a lease? A lease is where the company rather than buying the asset outright using available cash resources or borrowed funds it may lease/rent an asset. Who are the parties involved in a lease? Lessor the owner of the asset Lessee the user of the asset who does so on payment of specific rentals over a period

What are the different types of leases? Operating lease Financing lease

What is an operating lease? An operating lease is a lease where the lessor retains most of the risk and rewards of ownership. In operating lease the lessor supplies the equipment to the lessee. The lessor is responsible for servicing and maintaining the leased equipment and the period of lease is fairly short (less than the economic life of the asset). At the end of the lease the lessor can either rent the equipment to someone else or sell the equipment.

What is a Financing lease? A finance lease is a lease that transfers substantially all of the risks and rewards of ownership of an asset to the lessee. The lessee is responsible for maintenance and service of the asset and the period of the lease will cover most or all of the economic useful life. At the end of the lease the lessor will not be able to sell the asset because of severe wear and tear but the lessor would have ensured that the full cost of the asset as well as a suitable return is made. What is sale and leaseback? Sale and leaseback is when a business that owns an asset agrees to sell the asset to a financial institution and leases it back. The business retains use of the asset but has the funds from the sale. What are the advantages of Sale and Leaseback? The supplier of the equipment is paid in full at the beginning The supplier has no other financial concern about the asset The lessor makes return out of the lease payments from the lessee The lessor will be entitled to capital allowance on his purchase of the equipment The lessee will be entitled to tax relieve on the rents It is easier to obtain than a bank loan It may be cheaper than a bank loan

Example on BPP page 187 Operating Lease vs. Financing Lease

Updated 10/25/2010 THE END