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

Summary

  1. Time value of money;
  2. Investment appraisal techniques:
    1. Discounted cash flow (DCF) techniques (Net Present Value and Internal Rate of Return);
    2. Payback;
    3. Accounting-based techniques;

TIME VALUE OF MONEY AND INVESTMENT APPRAISAL.

Comparing costs and benefits of any proposed investment is complicated by:

  • Timing of costs and benefits – these may take place at different times in the same investment project, and competing projects may have different durations.
  • Identification and quantification of costs and benefits.
  • Risks – different flows may be associated with different risks
  • Exchange rates – in international investments/projects, costs and benefits may arise in different currencies.

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:

  • How much will revenues increase as a result of a proposed action/project?
  • How will demand change if the price is changed? And how will competitors respond?
  • How will the project affect short and long term production costs or productivity? What is the risk of obsolescence?

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.

 

  1. Time value of money- SEE PRESENTATION SLIDES
  2.  Investment appraisal

There are 4 methods commonly used in practice by businesses to evaluate investment opportunities:

  1. Net Present Value
  2. Internal rate of return
  3. Payback period
  4. Accounting Rate of Return

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:

  1. IDENTIFY RELEVANT CASH FLOWS…
  • Cash flows not accounting profits
  • Non-cash items such as depreciation should not be included in internal decision-making calculations
  • All cash inflows and outflows that change as a result of the investment are relevant
  • Only cash inflows / outflows that change are relevant – past costs (“sunk costs”) are not themselves relevant.
  • Financing costs (e.g. loan charges) should not be included in cash flows – financing is taken into account by the discount rate.
  1. DETERMINE APPROPRIATE DISCOUNT RATES …

…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

  1. NET PRESENT VALUE (NPV) DECISION RULE:

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.

Ex.1.

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.

Period

 

Cashflow £
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

 

Period

 

Cash flow (£) Discount factor Present value (£)
0 (450,000)    
1 350,000    
2 100,000    
3 100,000    
4 80,000    
    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.

Ex.2.

For a stand-alone investment, the following net cash flows have been identified:

Year 0 Year 1 Year 2 Year 3
-£9,514 £1,000 £5,000 £9,000

 

 

Find the IRR of the investment by trial and error.

Method.

(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

than 1

 

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:

  1. i) comparison of NPVs.
  2. ii) comparison of incremental IRR to discount rate.

iii) calculate NPV on incremental cash flows.

Incremental investment appraisal:

  • Consider the smaller project and assess whether it is acceptable.
  • If it is acceptable, identify the incremental cash flows of the larger project over the smaller one, and calculate the incremental IRR – if this is equal to or higher than the opportunity cost of capital then additional investment in the larger project is worthwhile.

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:

  • Its operational simplicity.
  • Arguably it may not be too misleading for the many small investment decisions which are made in practice where the prediction of longer-term cash flows is not critical to the acceptance decision.
  • Even if DCF methods are used, payback may be used as a rough screening device.
  • Useful for cash flows which are subject to extreme uncertainty in the long term.

Criticisms of payback period:

  • Does not evaluate all cash flows; ignores flows after the payback period.
  • Does not take into account the timing of cash flows.
  • The choice of critical period is subjective.

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%

Investment

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:

  • ARR uses accounting profit; an increase in profit can be seen as a net increase in wealth over the period and ARR does take into account all the profits of a project, however profit only appropriate for short term evaluation, cash flows more appropriate when considering performance over the lifetime of a project -Cash acquires resources and is distributed to shareholders.
  • ARR related to size of the investment- logical.
  • ARR expressed as a percentage- some managers more comfortable using percentage measures.

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