ABM1320 Advanced Corporate Finance 2019/20
TIME VALUE OF MONEY AND INVESTMENT APPRAISAL
Context: The Investment Decision- Making Process
|1. Determine investment funds available|
|2. Identify profitable project opportunities|
|Investment Appraisal||3. Define and classify proposed projects|
|4. Evaluate the proposed project(s)|
|5. Approve the project(s)|
|6. Monitor and control the project(s)|
Atrill (2003) Chapter 4
TIME VALUE OF MONEY AND INVESTMENT APPRAISAL.
Comparing costs and benefits of any proposed investment is complicated by:
Nonetheless, the investment appraisal techniques outlined here aim to express all quantifiable costs and benefits in the same terms. Hence: –
Costs and benefits are expressed in monetary terms. Arriving at these will often be difficult and will require a wide-ranging analysis drawing on a full range of business disciplines. For instance:
All relevant quantifiable costs and benefits must be brought into the analysis – that is all changes resulting from the investments under consideration irrespective of the accounting classification of the cash flows involved. Truly unquantifiable benefits and costs present more of a problem. The key concept here is relevant cost / benefit.
The timing of costs and benefits must be known, and the impact of timing on the decision evaluated. To evaluate all alternatives in the same terms means appraising their value at the same point in time. This introduces the key concept of the time value of money. Specifically, utilizing the time value of money concept allows us to compare present values of future costs and benefits.
There are 4 methods commonly used in practice by businesses to evaluate investment opportunities:
Generally cash flows are considered more relevant to investment decision making; it is cash that is the driver of shareholder value. However, accounting decision techniques such as ARR (see below) are based on profits.
When cash flows arise in different periods, it is necessary to take account of timing, which is seen most clearly in discounted cash flow techniques (NPV or IRR).
2 (a) Discounted cash flow (DCF) techniques.
Net present value of a stream of cash flows:
NPV = ∑ (Cn /(1 + r)n )
NPV is the present value of cash flows adjusted by the cost of the investment. It is the present values of all the cash flows associated with a project and the net present value of the project as a whole.
NPV should be found using the following steps:
…the appropriate interest rate / discount rate is the cost of capital or opportunity cost of capital.
iii. DISCOUNT FUTURE CASH FLOWS TO EQUIVALENT PRESENT VALUES
In the absence of scarce resources, an organization should accept all opportunities with positive NPVs and reject those with negative NPVs.
If competing projects the project with the highest NPV should be accepted. Where the decision is a choice between mutually exclusive investments, the decision rule is to rank projects by NPV: the larger the positive NPV the more advantageous the project.
MRW ltd is considering investing in new production equipment costing £450,000. The equipment will increase capacity, reduce wastage and will need less frequent maintenance. The level of demand for the product currently exceeds capacity, and is expected to remain high for the next three years before declining and finally becoming obsolete after four years. The net cash flows as result of these changes are set out below.
Calculate the net present value, assuming a discount rate of 14%.
Explain the meaning of the NPV.
|Now (year 0)
|Outlay on equipment||(450,000)|
|Year 1||Net cash inflow||350,000|
|Year 2||Net cash inflow||100,000|
|Year 3||Net cash inflow||100,000|
|Year 4||Net cash inflow||80,000|
|Cash flow (£)||Discount factor||Present value (£)|
|NET PRESENT VALUE|
The NPV of this project is positive. This means that the present value of the future benefits is greater than the present value of the costs, hence (from a financial perspective) it is beneficial to the organisation to accept the project.
An important caveat for all techniques concerns sensitivity to estimation error in the data. Specific to DCF techniques, is the importance of establishing just how sensitive is the NPV recommendation to changes in discount rate, particularly if there is any uncertainty as to the estimation of that rate.
INTERNAL RATE OF RETURN (IRR)
The Internal rate of return is the discount rate that gives a zero NPV for a series of cash flows:
0 = ∑ (Cn /(1 + r)n )
In using this technique, we do not seek to generate a cash figure to determine whether an investment should be undertaken, but rather seeks to find the discount rate at which the NPV of a project is zero. This discount rate is compared with a ‘Hurdle rate’, which is the market required rate of return; i.e. the market determined opportunity cost of funds. Through this comparison, the IRR also signals acceptance or rejection of an investment, but is expressed in percentage terms, not in cash terms.
Managers using IRR must have a minimum IRR in mind-hurdle rate and for any project to be acceptable it must meet the minimum IRR requirement. For competing projects the highest IRR should be selected.
For a stand-alone investment, the following net cash flows have been identified:
|Year 0||Year 1||Year 2||Year 3|
Find the IRR of the investment by trial and error.
(i) Assume an initial estimate of 10%:
(ii) If NPV is positive at 10%, this rate of return is too low. Try 20%:
Hence the project yields a percentage return of 20% p.a.
For this example if the hurdle rate was 15% then with the IRR as 20% the project would be selected.
The approximate IRR is generally found using this iteration method, as it is not easily calculated directly.
SEE PRESENTATION SLIDES
In situations where management must decide whether to accept or reject a single project, the IRR criterion gives the same advice as NPV, provided that the cash flow pattern is orthodox (i.e. that one or more cash outflows is followed by a series of cash inflows).Unfortunately, there are several problems with applying IRR in more complicated situations.
Two problems with IRR affecting both independent and mutually exclusive projects can be seen by comparing it with the NPV method:
|Flows||Number of IRR solutions||IRR criterion||NPV criterion|
|First cash flow negative and all others positive
|1||Accept if IRR > r
Reject if IRR < r
|Accept if NPV>0
Reject if NPV<0
|First cash flow positive and all others negative
|1||Accept if IRR < r
Reject if IRR > r
|Accept if NPV>0
Reject if NPV<0
|Some flows after first are positive and some flows after first are negative
|May be more
|No valid IRR
|Accept if NPV>0
Reject if NPV<0
Two further problems with IRR are specific to mutually exclusive projects:
(a) Scale: IRR ignores issues of scale. A high percentage return on a smaller investment can be more than offset by the ability to earn at least a decent return on a much bigger investment.
(b) Timing: When comparing mutually exclusive projects of identical scale, the timing of the cash inflows can lead to inappropriate advice from the IRR method.
In this type of situation, the investment decision can be based on:
iii) calculate NPV on incremental cash flows.
Incremental investment appraisal:
Comparing NPVs, incremental IRRs and incremental NPVs will give the same decisions.
2 (b) PAYBACK PERIOD
This technique differs conceptually and practically from the discounting techniques considered above.
It simply involves estimating the time period over which the cost of a particular investment is ‘paid back’. This payback period is then compared to some standard period to decide whether to accept the project. For a project to be acceptable it must fall within the maximum payback period. If a number of projects are being ranked, look for the shortest payback period.
Advantages of the Payback method are:
Criticisms of payback period:
2 (c) ACCOUNTING TECHNIQUES : Accounting Rate of Return (ARR)
The most common accounting technique for this purpose is the Accounting Rate of Return (ARR), which despite being flawed enjoys fairly wide acceptance.
The ARR = Average Annual Income × 100%
ARR takes the average accounting profit generated by the investment and expresses it as a percentage of the average investment made over the life of the project.
Return on Investment (ROI) is similar.
Because the ARR necessitates the use of accounting profits, accrued revenues and costs rather than yearly cash flows enter the calculations. Accounting profits also involve non-cash items e.g. depreciation.
Advantages and disadvantages: