P4 Chapter 02 Investment Appraisal

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P4 Chapter 2 Content
1 Free Cash Flow
2 NPV
3 IRR & MIRR
4 Discounted Payback Period
5 Duration
6 Capital Rationing
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P4 Chapter 2 Content
7 Past Paper
8 Analysis of Comprehensive Example

Chapter Summary
Investment
Appraisal
Free Cash Flow Economic Return
Calculation Using Modified

IRR
of FCF FCF IRR
From In Investment Multi-Period

Accounting Appraisal Captial
Infor Rationing
From First To Value A Firm
Linear
Principles
Programming
Solutions
Dealing Dealing
With Taxation With Inflation
PV of Dividends NPV
Formulation Formulation
1.Free Cash Flow
 Defination: Cash that is not retained and reinvested in the

business is called free cash flow.
 It represents cash flow availiable:
 to all the providers of captial of a company.
 to pay dividends or finance additional capital projects.
 Uses of free cash flow

 Evaluating potential investment projects
 Indicator of company performance e.g. Chapter 10: Corpora
te failure and reconstruction
 Calculate the value of a firm and thus a potential share price
e.g.Chapter 15:Business valuation.
1.Free Cash Flow
 Calculating free cash flow for investment appraisal

Free cash flow=Revenue - Costs - Investments
 FCF=PBIT+Dep'n-Tax-changes in WC
 Operating CF-Investment in operating capital
 FCF to Equity=FCF-Debt int and repays+loan cash raised
 Use of free cash flow in investment appraisal

 Net Present Value
 Internal Rate Of Return
 Modified Internal Rate Of Return
 Discounted Payback Period
 Duration (Macauley Duration and Modified Duration)

2.NPV
 Capital investment projects are best evaluated using the n

et present value(NPV)technique.
 Some basic NPV concepts ( relevant cash flows, discounti
ng, the impact of inflation, the impact of taxation) are cove
red below.
 Relevant Cash Flows
 Relevant cash flows are those costs and revenues that are:
 future
 incremental
 You should ignore:
 sunk costs non-cash items
 committed costs apportioned overheads

2.NPV
 Discounting
Discounted cash flow techniques:

• Take account of the time value of money
• Seek to improve shareholders' wealth
Compounding: Discounting:
• Calculates a terminal value: • Calculates a present value:
TV=CF(1+r)n e.g. T0 value
PV of a single sum: PV of a perpetuity: PV of an annuity:

CF Annuity * AFi where
P  F (1  r )  n Perpetuity *1 / r
(1  r ) n 1  (1  r )  n
AF is r
Advanced annuities/perpetuities: Delayed annuities/perpetuities:

• Ignore T0 flow • Apply factor as normal
• Add i to the AF/Perpetuity factor • Discount back to T 0

T0 T1 T2 T3 T4 T5 T6

2.NPV
 The impact of inflation

 Inflation is a general increase in prices leading to a general decline in
the real value of money.
 In times of inflation, the fund providers will require a return made up
of two elements:
 Real return for the use of their funds.
 Additional return to compensate for inflation.
 Real and nominal rates are linked by the formula:
(1+i)=(1+r)(1+h)
r=real rate
i=money/nominal interest rate
h=general inflation rate

2.NPV
 Investment appraisal two types of inflation need considera

tion：
Two type of inflation
Specific inflation rate General rate of inflation
Impact all the individual Impact the investors'

cash flow items-Each overall required rate of
cash flow is affected return.
by a specific rate.
Investors in the project
need compensation for
their lost purchasing
power, which relates
to their ability to buy
a basket of all goods.
Rather than any spe
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2.NPV
 The impact of inflation

methods of dealing
with inflation
Real method Money/Nominal method
1. Do not inflate the

1. Inflate each cash flow
cash flows-leave them
by its specific inflation
in real terms,i.e. in
rate. i.e. convert it to a
today's(T0) prices-real
money rate
flows
2. Discount using the 2. Discount using the

real rate money rate
REAL / real MONEY / money
BE CONSISTENT
2.NPV
 The impact of taxation

There are two main impacts of taxation in an investment apprais
al:
 Tax is charged on operating cashflows
 Tax allowable depreciation ( sometimes refered to as capital

allowances or writing down allowances ) can be claimed, thus
generating tax relief.

2.NPV

The basic rules that follow are based on the current UK tax legi
slation
 TAD is calculated on a reducing balance basis
 The total TAD given over the life of an asset equates to the fall
in value over the period.
 TAD is claimed as early as possible
 TAD is fiven for every year of ownership except the tear of dis
posal
 In the year of sale or scrap a balancing allowance or charge a

rises

2.NPV

$
Original cost of asset X
Cumulative TAD claimed (X)
——
Written down value of the asset X
Disposal value of the asset (X)
——
Balancing allowance or charge X
——

2.NPV
 Illustration:Taxation in investment appraisal

A company buys an asset for $26,000.It will be used on a project for t
hree years after which it will be disposed of on the final day of year 3.
Tax is payable at 30% and tax allowable depreciation is available at
25% reducing balance.
A Calculate the tax allowable depreciation and hence the tax saving
s for each year if the proceeds on disposal of the asset are $12,500
B If net trading income from the project is $16,000 pa and the cost of
capital is 8% calculate the free cash flows and hence the net present
value (NPV) of the project.

2.NPV
 Solution
Time $ Tax saving Timing
$ of tax relief
T0 Initial investment 26,000
T1 TAD@25% (6,500) 1,950 T1
——
Written down value 19,500
T2 TAD@25% (4,875) 1,463 T2
——
Written down value 14,625
Sale proceeds (12,500)
——
T3 Balancing allowance 2,125 638 T3

2.NPV
Time T0 T1 T2 T3
Net trading inflows 16,000 16,000 16,000
Tax payable(30%) (4,800) (4,800) (4,800)
—— —— —— ——
Post tax operating flows 11,200 11,200 11,200
Initial investment (26,000)
Scrap proceeds 12,500
Tax relief on TAD 1,950 1,463 638
—— —— —— ——
Free cash flows (26,000) 13,150 12,663 24,338
Discount factor@8% 1,000 0.926 0.857 0.794
—— —— —— ——
Present value (26,000) 12,177 10,857 19,324
—— —— —— ——
NPV 16,353
3.IRR&MIRR
 IRR-The Basics
The IRR of a project has the following features:
 It represents the discount rate at which the NPVof an investment is
zero
 It can be found by linear interpolation
NL
IRR  L  * ( H  L)
(NL  NH )
 Standard projects(outflow followed by inflows) should be accepted
if the IRR exceeds the cost of capital.
 The IRR provides a decision rule for investment appraisal, but also pr
ovides information about the riskiness of a project- i.e. thesensitivity
of its returns.The project will only continue to have a positive NPV whi
lst the firm's cost of capital is lower than the IRR.

3.IRR&MIRR
 Problems with using IRR

 The decision rule is not always clear cut. For example, if a project
has 2 IRRs(or more), it is difficult to interpret the rule which says "a
ccept the project if the IRR is higher than the cost of capital"
 The assumptions. IRR is often mistakenly assumed to be a measu

re of the reuturn from a project, which it is not. The IRR only repres
ents the return from the project if funds can be reinvested at the IR
R for the duration of the project.
 Choosing between projects.Since projects can have multiple IRRs

(or none at all) it is difficult to usefully compare projects using IRR.

3.IRR&MIRR
 MIRR
 MIRR measures the economic yield of the investment under the as
sumption that any cash surpluses are reinvested at the firm's curre
nt cost of capital.
 Calculation of MIRR
MIRR  [ PVR / PVI ]1/ n (1  re )  1

Where
PVR=The present value of the "return phase"of the project
PVI=The present value of the "investment phase"of the project
re=The firm's cost of capital

3.IRR&MIRR
 Example
A project with the following cash flows is under consideration:
$000 T0 T1 T2 T3 T4
(20,000) 8,000 12,000 4,000 2,000
Cost of capital 8%
MIRR?
Solution:
PVR=22,340(This is the present value of the year 1-4 cash flows)
PVI=20,000
1+MIRR=(1+re)*(PVR/PVI)1/n=1.08*（22,340/20,000）1/4=1.1103,
giving MIRR= 11%pa.

4.Discounted Payback Period
 Traditional payback period

 The payback period was introduced in paper F9
 Payback period measures the length of time it takes for the ca
sh returns from a project to cover the initial investment.
 The main problem with payback period is that it does not take
account of the time value of money
 Discounted payback period
 Discounted payback period measures the length of time befo
re the discounted cash returns from a project cover the initial
investment
 The shorter the discounted payback period, the more attracti
ve the project is. A long discounted payback period indicates
that the projct is a high risk project.

4.Discounted Payback Period
 Example
$000 T0 T1 T2 T3 T4
(20,000) 8,000 12,000 4,000 2,000
Cost of capital 8%
Calculate the discounted payback period
Solution
Year Discounted cash flow Cumulative discounted cashflow
0 (20,000) (20,000)
1 8,000/1.08=7,407 (12,593)
2 12,000/1.08 2=10,288 (2,305)
3 4,000/1.08 3=3,175 875
DPP=2Y+(2,305/3,175)=2.73Y

5.Duration(Macauley duration)
 Concept of Duration
 Duration measures the average time to recover the present v
alue of the project(if cash flows are discounted at the cost of c
apital).
 Duration captures both the time value of money and the whol
e of the cash flows of a project.
 Projects with higher durations carry more risk than projects wi

th lower durations.
 If cashflows are discounted at the project's IRR, it can be use

d to measure the ime to recover the initial investment

 Comparision among three techniques
Payback period Discounted payback period

• fail to take into account • take into account
the time value of money the time value of money
• fail to take into account • it is possible for projects
cash flows beyond the with highly negative terminal
project date. cash flows to appear attractive
Duration
• Duration measures either the average time to
recover the initial investment, or to recover the
present value of the project if discounted at the
cost of capital
• Duration captures both the time value of
money and the whole of the cf of a project

$000 T0 T1 T2 T3 T4
(20,000) 8,000 12,000 4,000 2,000
Cost of capital 8%
Calaculate the project's Macauley duration
Solution
The Maculey duration is calculated by first calculating the discounted cas

h flow for each future year, and then weighting each discounted cash flow
according to its time of receipt, as follows:
$000 T0 T1 T2 T3 T4
cash flow 8,000 12,000 4,000 2,000

$000 T0 T1 T2 T3 T4
cash flow 8,000 12,000 4,000 2,000
DF@8% 0.926 0.857 0.794 0.735
PV@8% 7,408 10,284 3,176 1,470
PV*Year 7,408 20,568 9,528 5,880
Next, the sum of the (PV*Year)figure is found, and divided by the present
value of these "return phase" cash flows
Sum of (PV*Year)figures=7,408+20,568+9,528,5,880=43,384
Present value of return phase cash flows=7,408+10,284+3,176+1,470=22,
338
Hence,the Macauley duration is 43,384/22,338=1.94years

 Modified Duration
 Macaulay Duration is the name given to the weighted average time
until cash flows are received, and is measured in years.
 Modified Duration is the name given to the price sensitivity and is t

he percentage change in price for a unit change in yield.
 Macaulay Duration and Modified Duration differ slightly, and there i
s a simple relationship between the two:
Modified Duration=Macauley Duration/(1+cost of capital)
 Q1 (b) June 2014

6.Capital rationing
 Capital rationing- single period
Capital rationing is where there are insufficient funds to undertak

e all possible positive NPV projects to maximise shareholder wealth.
 independent and divisible(PI Method)
 independent and indivisible(Trial and Error Approach)
 mutually exclusive(Pick the one with the highest positive NPV)
 Past paper:Slow Fashions Co (6/09)

6.Capital rationing
 Multi-period capital rationing
A solution to a multi-period capital rationing problem cannot be fo

und using PIs. This method can only deal with one limiting factor. Her
e there are a number of limiting factors and linear programming techn
iques must therefore be applied.
However, linear programming(LP) is not expected to produce in th

e exam.The linear programme is formulated in three stages:
 Define the unknowns
 Formulate the objective function
 Express the constraints in terms of inequalities including the non-

ngegativities

6.Capital rationing
 The impact of corporate reporting on investment appraisal

 Impact on shareholder wealth. e.g. the share price
 Impact on reported financial position e.g. gearing
 Performance of the firm e.g. ROCE, EPS.

Past paper
 Past Paper for investment appraisal DCF techniques

Jonas Chemical Systems(BPP Q13) CD(BPP Q13)
Slow Fashions Co (6/09) Your business (6/09)
Kodiak Company (12/09) Tisa Co (6/12)
Arbore Co (12/12) Neptune (6/08)
Chmura Co (12/13) Blipton International (12/08)
Jupiter Co (12/08) Trosoft (SFM, 12/04)
Seal Island (6/10) Sleepon (SFM, 12/05)

Analysis of Example
You have been conducting a detailed review of an investment project

proposed by one of the divisions of your business. Your review has two aims:
first to correct the proposal for any errors of principle and second, to
recommend a financial measure to replace payback as one of the criteria for
acceptability when a project is presented to the company's board of
directors for approval. The company's current weighted average cost of
capital is 10% per annum.
The initial capital investment is for $150 million followed by $50 million one
year later. The post tax cash flows, for this project, in $million, including the
estimated tax benefit from capital allowances for tax purposes, are as
follows:

Analysis of Example
Company tax is charged at 30% and is paid/recovered in the year in which

the liability is incurred. The company has sufficient profits elsewhere to
recover capital allowances on this project, in full, in the year they are
incurred. All the capital investment is eligible for a first year allowance for
tax purposes of 50% followed by a writing down allowance of 25% per
annum on a reducing balance basis.
You notice the following points when conducting your review:
1. An interest charge of 8% per annum on a proposed $50 million loan has
been included in the project's post tax cash flow before tax has been
calculated.
2. Depreciation for the use of company shared assets of $4 million per
annum has been charged in calculating the project post tax cash flow.
3. Activity based allocations of company indirect costs of $8 million have
been included in the project's post tax cash flow. However, additional
Analysis of Example
corporate infrastructure costs of $4 million per annum have been ignored

which you discover would only be incurred if the project proceeds.
4. It is expected that the capital equipment will be written off and disposed of
at the end of year six. The proceeds of the sale of the capital equipment are
expected to be $7 million which have been included in the orecast of the
project's post tax cash flow. You also notice that an estimate for site
clearance of $5 million has not been included nor any tax saving recognised
on the unclaimed writing down allowance on the disposal of the capital
equipment.
Required(:a) Prepare a corrected project evaluation using the net present
value technique supported by a separate assessment of the sensitivity of the
project to a $1 million change in the initial capital expenditure.
(b) Estimate the discounted payback period and the duration for this project
commenting on the relative advantages and disadvantages of each method.
(5 marks)

Solution of Example
(a) The first thing to do in this question is to determine how to correct the errors of pri
nciple.
(1) Interest should not be included as this is already accounted for in the discount rat
e. The annual interest charge of $4 million (less tax of 30%) should be added back to
the cash flow in each year.
(2) Depreciation is not a cash flow and should be ignored in NPV calculations. The a
nnual charge of $4million (less tax at 30%) should be added back to the cash flow in
each year.
(3) Indirect allocated costs are not relevant. These should be added back to the annu
al cash flows (net of tax). Corporate infrastructure costs are relevant to the project an
d should have been included. These costs should be deducted from annual cash flow
figures (net of tax), as should the estimates for site clearance.
(4) Capital allowances in year 6 should be accounted for.

Solution of Example

Solution of Example

Solution of Example

Solution of Example
(b) Discounted payback and duration

Discounted payback is used to determine how long it will take the project to repay its original i
nvestment. As the name suggests this method uses discounted cash flows in the calculations.
The discounted payback period is approximately 4.5 years.

Solution of Example
Project duration is the time it takes the project to recover approximately 50%
of its initial investment. It is calculated by weighting each year of the project by
the percentage of the present value recovered in that year.

Solution of Example
Discounted payback overcomes one of the problems of the ordinary payb

ack technique – that is, it uses discounted cash flows rather than ignoring t
he time value of money. However the problem with payback (discounted or
not) is that it ignores cash flows that occur beyond the payback period. Thu
s projects that have very high initial cash flows but few (if any) in later year
s may be favoured over those projects that might add greater value to the fi
rm but over a longer period.
The advantage of duration is that it considers the cash flows over the entir
e life of the project. It measures how long it will be before the project recov
ers the bulk of its present value. However it can be more difficult to underst
and the concept behind duration and for this reason it may not be widely us
ed.

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1 Free Cash Flow

3 IRR & MIRR

4 Discounted Payback Period

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8 Analysis of Comprehensive Example

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Free Cash Flow Economic Return

Calculation Using Modified

From In Investment Multi-Period

 Defination: Cash that is not retained and reinvested in the

 Uses of free cash flow

 Calculating free cash flow for investment appraisal

 Use of free cash flow in investment appraisal

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 Capital investment projects are best evaluated using the n

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Discounted cash flow techniques:

PV of a single sum: PV of a perpetuity: PV of an annuity:

Advanced annuities/perpetuities: Delayed annuities/perpetuities:

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 The impact of inflation

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 Investment appraisal two types of inflation need considera

Specific inflation rate General rate of inflation

Impact all the individual Impact the investors'

 The impact of inflation

Real method Money/Nominal method

1. Do not inflate the

2. Discount using the 2. Discount using the

REAL / real MONEY / money

 The impact of taxation

 Tax is charged on operating cashflows

 Tax allowable depreciation ( sometimes refered to as capital

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 The impact of taxation

 TAD is calculated on a reducing balance basis

 TAD is claimed as early as possible

 In the year of sale or scrap a balancing allowance or charge a

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 The impact of taxation

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 Illustration:Taxation in investment appraisal

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 Problems with using IRR

 The assumptions. IRR is often mistakenly assumed to be a measu

 Choosing between projects.Since projects can have multiple IRRs

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MIRR  [ PVR / PVI ]1/ n (1  re )  1

PVR=The present value of the "return phase"of the project

PVI=The present value of the "investment phase"of the project

re=The firm's cost of capital

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(20,000) 8,000 12,000 4,000 2,000

giving MIRR= 11%pa.

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 Traditional payback period

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