Capital Investment Appraisal 382g57
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Capital investment: investment appraisal Managing financial resources & decisions (H/601/0548)
Nurul Afza Binti Abd Rashid
1
Investment Appraisal • A means of assessing whether an investment project is worthwhile or not
• Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc
• Used in both public and private sector
2
Investment Appraisal • Why do companies invest? • Importance of ing investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank!
• Buy equipment/machinery or build new plant to: • Increase capacity (amount that can be produced) which means: • Demand can be met and this generates sales revenue • Increased efficiency and productivity 3
METHODS OF CAPITAL INVESTMENT APPRAISAL Payback Net Present Value
Internal Rate of Return
Discounted payback Proposed Capital Project ing Rate of Return 4
5
1.
The PAYBACK method
• The payback method is an attempt to estimate how long it would take before a project begins to pay for itself.
• Example : If a company was going to spend RM 300,000 on purchasing some new plant, the ant would calculate how many years it would take before RM 300,000 had been received back in cash.
• The recovery of an investments in a project is usually measured in of net cash flow. Net cash flow is the difference between cash received and cash paid during a defined period of time. 6
The PAYBACK method • The Newland City Council has investigated the possibility of investing in a new project, and the following information has been obtained. RM
RM
Total cost project
500,000
Expected net cash flows: Year 1
20,000
2
50,000
3
100,000
4
200,000
5
300,000
6
30,000
Net Return
(700,000) 200,000
7
The PAYBACK method Year
Net cash flow
Cumulative net cash flow
(500,000)
(500,000)
1
20,000
(480,000)
2
50,000
(430,000)
3
100,000
(330,000)
4
200,000
(130,000)
5
300,000
170,000
6
30,000
200,000
Year 0
8
The PAYBACK method • By the year end of fifth year, the original investment of RM 500,000 will have been covered.
• However, the exact years that investments will be covered is 4 years and 5 months [(RM 130,00 / RM 300,000) x 12 months].
9
2.
The DISCOUNTED PAYBACK method
Year
Net Cash Flow (2)
Discount factors (3)
Present Value at 8 % [Column (2) x Column (3)] (4)
Cumulative present value (5)
(1) 0
(500,000)
1.0
(500,000)
(500,000)
1
20,000
0.9259
18,518
(481,482)
2
50,000
0.8573
42,865
(438,617)
3
100,000
0.7938
79,380
(359,237)
4
200,000
0.7350
147,000
(212,237)
5
300,000
0.6806
204,180
(8,057) 10
6
30,000
0.6302
18,906
10,849
The DISCOUNTED PAYBACK method • By the year end of sixth year, the original investment of RM 500,000 will have been covered.
•
However, the exact years that investments will be covered is 5 years and 5 months [(RM 8,000 / RM 19,000) x 12 months].
11
ing Rate of Return • The ing rate of return(ARR) method attempts to compare the profit of a project with the capital invested in it.
• Using the formula : ARR = Average annual net profit before interest and taxation x 100 Initial capital employed on the project
12
3.
ing Rate of Return
Bridge Limited is considering investing in a new project, the details of which are as follows: RM
RM
Total cost project (5 years)
50,000
Estimated net profit: Year 1
12,000
2
18,000
3
30,000
4
25,000
5
5,000
Total Net Profit
13
90,000
ing Rate of Return • The ing rate of return would be calculated as follows : Average annual net profits
x 100
Cost of the investment Average annual net profits = RM 18,000 (RM 90,000/5) » ing Rate of Return = RM 18,000 x 100 = 36 % RM 50,000 14
ing Rate of Return In evaluating an investment project, the ARR of the project is compared with a predetermined minimum acceptable ing Rate of return:
ARRs < minimum acceptable rate = minimum acceptable rate > minimum acceptable rate Highest
Comments Reject project Accept project Accept project Choose highest ARR 15
4. Net Present Value • The NPV method recognizes that cash received today is preferable to cash •
• •
receivables sometimes in the future. When facing different investment proposals, the management should choose the project that can generate the greatest addition of value to the company. Net present value (NPV) method is a process that uses the discounted cash flow of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return With the NPV method, we can compare the return on investment in capital projects with the return on an alternative equal risk investment in securities traded in financial market 16
Steps to be considered in calculating NPV
• 1. • 2. • 3. • 4.
Calculate the annual net cash flows expected to arise from the projects. Select an appropriate rate of interest, or required rate of return. Compare the total net present value with the initial outlay. Accept the project if the total NPV is positive.
17
Net Present Value Project
ALPHA
BETA
Estimated life
3 years
5 years
Commencement date
1.1.2001
1.1.2001
Project cost at year 1
100,000
100,000
Year 1
20,000
10,000
2
80,000
40,000
3
40,000
40,000
4
0
40,000
5
0
20,000
140,000
150,000
Estimated net cash flows:
18
Net Present Value Year
ALPHA
BETA
Net Cash Flow RM
Discount Factor 10 %
Present Value RM
Net Cash Flow RM
Discount Factor 10%
Present Value RM
(1)
(2)
(3)
(4)
(5)
(6)
(7)
1
20,000
0.9091
18,182
10,000
0.9091
9,091
2
80,000
0.8264
66,112
40,000
0.8264
33,056
3
40,000
0.7513
30,052
40,000
0.7513
30,052
4
-
0
-
40,000
0.6830
27,320
5
-
0
-
20,000
0.6209
12,418
Total present value
114,346
Less : Initial cost
(100,000)
Net present value
14,346
111,937 (100,000) 19 11,937
Interpreting the NPV derived as follows: NPVs Comments <0 Reject the project
Reasons The rate of return from the project is small than the rate of return from an equivalent risk investment
=0
Indifferent to accept or reject the project
The rate of return from the project is equal to the rate of return from an equivalent risk investment
>0
Accept the project
The rate of return from the project is greater than the rate of return from an equivalent risk investment
Highest Accept the project
If various project are considered, the project with highest positive NPV should be chosen
20
Internal Rate of Return • The internal rate of return is the annual percentage return achieved by a project, of which the sum of discounted cash inflow over the life of the project is equal to the sum of discounted cash outflows
• If the IRR is used to determine the NPV of a project, the NPV will be zero. • The company will accept this project only if the IRR is equal to or higher than the minimum rate of return or the cost of capital
21
Internal Rate of Return Example :
•
Bruce Limited is considering whether to invest RM 50,000 in a new project. The project’s expected net cash flows would be as follows: Year
RM
1
7,000
2
25,000
3
30,000
4
5,000
22
Internal Rate of Return Year (1)
Net Cash Flow (2)
Discount Factors
Present Value
(3)
(4)
(5)
(6)
10 %
15%
10%
15%
RM
RM
RM 1
7,000
0.9091
0.8696
6,364
6,087
2
25,000
0.8264
0.7561
20,660
18,903
3
30,000
0.7513
0.6575
22,539
19,725
4
5,000
0.6830
0.5718
3,415
2,859
52,978
47,574
(50,000)
(50,000)
2,978
(2,426)
Total present values Initial cost Net Present Value
23
Internal Rate of Return •
Break-Even Rate of Return
IRR = Positive Rate +
Positive NPV
x Range of rates
Positive NPV + Negative NPV*
So, solution : IRR
=
10% +
2,978
x (15% - 10 %)
(2,978 + 2,426) =
10 % + (0.5511 x 5%)
=
10% + 2.76%
=
12.76%
24
INVESTMENT APPRAISAL
ADVANTAGES AND DISADVANTAGES OF METHODS OF CAPITAL INVESTMENTS APPRAISAL
25
The PAYBACK Method Advantages
Disadvantages
1. Payback can be important: long payback means capital tied up and high investment risk.
1. It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return.
2. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.
2. It ignores the time value of money. Only suitable for short-term only.
3. Can be used as a supplementary. It focuses on the cash recovery of an investment.
3. It is unable to distinguish between projects with the same payback period. 4. It may lead to excessive investment in short-term projects.
26
ing Rate of Return Advantages
Disadvantages
1. The method is compatible with a similar ing ratio used in financial ing.
1. Does not take of the time value of money
2. It is relatively easy to understand and not difficult to compute.
2. ARR method seems to be less reliable than the NPV method. It adopts the ing profit instead of cash flows calculation. The change of depreciation method may also alter the ing profit
3. It draws attention to the notion of overall profit.
27
Net Present Value Advantages
Disadvantages
1. Consistency with the time value of money concept
1. It is difficult to estimate accurately the net cash flow for each year of the project’s life.
2. Consideration of all cash flows
2. Some difficulties may incurred in estimating the initial cost of the project and the time periods in which instalments must be paid back.
3. Adoption of cash flows instead of ing profit
3. It is not easy to select an appropriate rate of interest.
4. It is easy to compare the NPV of different projects and to reject projects that do not have an acceptable NPV.
28
Internal Rate of Return Advantages
Disadvantages
1. Attention is given to the timing of net cash flows.
1. It is not easy to understand.
2. An appropriate rate of return does not have to be calculated.
2. It is difficult to determine which two suitable rates to adopt.
3. The method gives a clear percentages return on a investments.
3. The method gives an approximate rate of return. 29
Conclusion • NPV is considered to be a highly acceptable method of Capital Investment Appraisal. It takes into the timing of net cash flows, the project’s profitability, and the return of the original investment.
• However, an entity would not necessarily accept a project just because it had an acceptable NPV, because there are many non-financial factors that must be allowed for.
• Furthermore, other less profitable projects (or even projects with a negative NPV) may ahead, perhaps because they are concerned with employee safety or welfare. 30
Nurul Afza Binti Abd Rashid
1
Investment Appraisal • A means of assessing whether an investment project is worthwhile or not
• Investment project could be the purchase of a new PC for a small firm, a new piece of equipment in a manufacturing plant, a whole new factory, etc
• Used in both public and private sector
2
Investment Appraisal • Why do companies invest? • Importance of ing investment as the purchase of productive capacity NOT buying stocks and shares or investing in a bank!
• Buy equipment/machinery or build new plant to: • Increase capacity (amount that can be produced) which means: • Demand can be met and this generates sales revenue • Increased efficiency and productivity 3
METHODS OF CAPITAL INVESTMENT APPRAISAL Payback Net Present Value
Internal Rate of Return
Discounted payback Proposed Capital Project ing Rate of Return 4
5
1.
The PAYBACK method
• The payback method is an attempt to estimate how long it would take before a project begins to pay for itself.
• Example : If a company was going to spend RM 300,000 on purchasing some new plant, the ant would calculate how many years it would take before RM 300,000 had been received back in cash.
• The recovery of an investments in a project is usually measured in of net cash flow. Net cash flow is the difference between cash received and cash paid during a defined period of time. 6
The PAYBACK method • The Newland City Council has investigated the possibility of investing in a new project, and the following information has been obtained. RM
RM
Total cost project
500,000
Expected net cash flows: Year 1
20,000
2
50,000
3
100,000
4
200,000
5
300,000
6
30,000
Net Return
(700,000) 200,000
7
The PAYBACK method Year
Net cash flow
Cumulative net cash flow
(500,000)
(500,000)
1
20,000
(480,000)
2
50,000
(430,000)
3
100,000
(330,000)
4
200,000
(130,000)
5
300,000
170,000
6
30,000
200,000
Year 0
8
The PAYBACK method • By the year end of fifth year, the original investment of RM 500,000 will have been covered.
• However, the exact years that investments will be covered is 4 years and 5 months [(RM 130,00 / RM 300,000) x 12 months].
9
2.
The DISCOUNTED PAYBACK method
Year
Net Cash Flow (2)
Discount factors (3)
Present Value at 8 % [Column (2) x Column (3)] (4)
Cumulative present value (5)
(1) 0
(500,000)
1.0
(500,000)
(500,000)
1
20,000
0.9259
18,518
(481,482)
2
50,000
0.8573
42,865
(438,617)
3
100,000
0.7938
79,380
(359,237)
4
200,000
0.7350
147,000
(212,237)
5
300,000
0.6806
204,180
(8,057) 10
6
30,000
0.6302
18,906
10,849
The DISCOUNTED PAYBACK method • By the year end of sixth year, the original investment of RM 500,000 will have been covered.
•
However, the exact years that investments will be covered is 5 years and 5 months [(RM 8,000 / RM 19,000) x 12 months].
11
ing Rate of Return • The ing rate of return(ARR) method attempts to compare the profit of a project with the capital invested in it.
• Using the formula : ARR = Average annual net profit before interest and taxation x 100 Initial capital employed on the project
12
3.
ing Rate of Return
Bridge Limited is considering investing in a new project, the details of which are as follows: RM
RM
Total cost project (5 years)
50,000
Estimated net profit: Year 1
12,000
2
18,000
3
30,000
4
25,000
5
5,000
Total Net Profit
13
90,000
ing Rate of Return • The ing rate of return would be calculated as follows : Average annual net profits
x 100
Cost of the investment Average annual net profits = RM 18,000 (RM 90,000/5) » ing Rate of Return = RM 18,000 x 100 = 36 % RM 50,000 14
ing Rate of Return In evaluating an investment project, the ARR of the project is compared with a predetermined minimum acceptable ing Rate of return:
ARRs < minimum acceptable rate = minimum acceptable rate > minimum acceptable rate Highest
Comments Reject project Accept project Accept project Choose highest ARR 15
4. Net Present Value • The NPV method recognizes that cash received today is preferable to cash •
• •
receivables sometimes in the future. When facing different investment proposals, the management should choose the project that can generate the greatest addition of value to the company. Net present value (NPV) method is a process that uses the discounted cash flow of a project to determine whether the rate of return on that project is equal to, higher than, or lower than the desired rate of return With the NPV method, we can compare the return on investment in capital projects with the return on an alternative equal risk investment in securities traded in financial market 16
Steps to be considered in calculating NPV
• 1. • 2. • 3. • 4.
Calculate the annual net cash flows expected to arise from the projects. Select an appropriate rate of interest, or required rate of return. Compare the total net present value with the initial outlay. Accept the project if the total NPV is positive.
17
Net Present Value Project
ALPHA
BETA
Estimated life
3 years
5 years
Commencement date
1.1.2001
1.1.2001
Project cost at year 1
100,000
100,000
Year 1
20,000
10,000
2
80,000
40,000
3
40,000
40,000
4
0
40,000
5
0
20,000
140,000
150,000
Estimated net cash flows:
18
Net Present Value Year
ALPHA
BETA
Net Cash Flow RM
Discount Factor 10 %
Present Value RM
Net Cash Flow RM
Discount Factor 10%
Present Value RM
(1)
(2)
(3)
(4)
(5)
(6)
(7)
1
20,000
0.9091
18,182
10,000
0.9091
9,091
2
80,000
0.8264
66,112
40,000
0.8264
33,056
3
40,000
0.7513
30,052
40,000
0.7513
30,052
4
-
0
-
40,000
0.6830
27,320
5
-
0
-
20,000
0.6209
12,418
Total present value
114,346
Less : Initial cost
(100,000)
Net present value
14,346
111,937 (100,000) 19 11,937
Interpreting the NPV derived as follows: NPVs Comments <0 Reject the project
Reasons The rate of return from the project is small than the rate of return from an equivalent risk investment
=0
Indifferent to accept or reject the project
The rate of return from the project is equal to the rate of return from an equivalent risk investment
>0
Accept the project
The rate of return from the project is greater than the rate of return from an equivalent risk investment
Highest Accept the project
If various project are considered, the project with highest positive NPV should be chosen
20
Internal Rate of Return • The internal rate of return is the annual percentage return achieved by a project, of which the sum of discounted cash inflow over the life of the project is equal to the sum of discounted cash outflows
• If the IRR is used to determine the NPV of a project, the NPV will be zero. • The company will accept this project only if the IRR is equal to or higher than the minimum rate of return or the cost of capital
21
Internal Rate of Return Example :
•
Bruce Limited is considering whether to invest RM 50,000 in a new project. The project’s expected net cash flows would be as follows: Year
RM
1
7,000
2
25,000
3
30,000
4
5,000
22
Internal Rate of Return Year (1)
Net Cash Flow (2)
Discount Factors
Present Value
(3)
(4)
(5)
(6)
10 %
15%
10%
15%
RM
RM
RM 1
7,000
0.9091
0.8696
6,364
6,087
2
25,000
0.8264
0.7561
20,660
18,903
3
30,000
0.7513
0.6575
22,539
19,725
4
5,000
0.6830
0.5718
3,415
2,859
52,978
47,574
(50,000)
(50,000)
2,978
(2,426)
Total present values Initial cost Net Present Value
23
Internal Rate of Return •
Break-Even Rate of Return
IRR = Positive Rate +
Positive NPV
x Range of rates
Positive NPV + Negative NPV*
So, solution : IRR
=
10% +
2,978
x (15% - 10 %)
(2,978 + 2,426) =
10 % + (0.5511 x 5%)
=
10% + 2.76%
=
12.76%
24
INVESTMENT APPRAISAL
ADVANTAGES AND DISADVANTAGES OF METHODS OF CAPITAL INVESTMENTS APPRAISAL
25
The PAYBACK Method Advantages
Disadvantages
1. Payback can be important: long payback means capital tied up and high investment risk.
1. It ignores the timing of cash flows within the payback period, the cash flows after the end of payback period and therefore the total project return.
2. The method also has the advantage that it involves a quick, simple calculation and an easily understood concept.
2. It ignores the time value of money. Only suitable for short-term only.
3. Can be used as a supplementary. It focuses on the cash recovery of an investment.
3. It is unable to distinguish between projects with the same payback period. 4. It may lead to excessive investment in short-term projects.
26
ing Rate of Return Advantages
Disadvantages
1. The method is compatible with a similar ing ratio used in financial ing.
1. Does not take of the time value of money
2. It is relatively easy to understand and not difficult to compute.
2. ARR method seems to be less reliable than the NPV method. It adopts the ing profit instead of cash flows calculation. The change of depreciation method may also alter the ing profit
3. It draws attention to the notion of overall profit.
27
Net Present Value Advantages
Disadvantages
1. Consistency with the time value of money concept
1. It is difficult to estimate accurately the net cash flow for each year of the project’s life.
2. Consideration of all cash flows
2. Some difficulties may incurred in estimating the initial cost of the project and the time periods in which instalments must be paid back.
3. Adoption of cash flows instead of ing profit
3. It is not easy to select an appropriate rate of interest.
4. It is easy to compare the NPV of different projects and to reject projects that do not have an acceptable NPV.
28
Internal Rate of Return Advantages
Disadvantages
1. Attention is given to the timing of net cash flows.
1. It is not easy to understand.
2. An appropriate rate of return does not have to be calculated.
2. It is difficult to determine which two suitable rates to adopt.
3. The method gives a clear percentages return on a investments.
3. The method gives an approximate rate of return. 29
Conclusion • NPV is considered to be a highly acceptable method of Capital Investment Appraisal. It takes into the timing of net cash flows, the project’s profitability, and the return of the original investment.
• However, an entity would not necessarily accept a project just because it had an acceptable NPV, because there are many non-financial factors that must be allowed for.
• Furthermore, other less profitable projects (or even projects with a negative NPV) may ahead, perhaps because they are concerned with employee safety or welfare. 30
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