1 © 2008 Thomson South-Western

MANAGEMENT OF FINANCIAL RESOURCES AND

PERFORMANCE

SESSIONS 3& 4

INVESTMENT APPRAISAL METHODS

June 10 to 24, 2013

CA. Sonali Jagath Prasad

ACA, ACMA, CGMA, B.Com.

WESTFORD SCHOOL OF MANAGEMENT

Understand how to use appraisal

methods to manage financial resources

Session –Learning Outcome

Session -Takeaways

Evaluate how to assess strategic investment

opportunities

Understand what input data or information is

relevant for the assessment

Understand the rationale and interpretation of

investment evaluation methods

Learn how to analyse investments and justify

recommendations

I. INVESTMENTS

Investment Objectives

Manufacturing Company

Investment in fixed assets :

– Sales growth through enhanced capacity

– Product diversification through launch of new products

– Replacement of old plant and machinery

– Improve process/cost efficiencies

Financial Investment

– Set up a joint venture

– Take strategic stake through new venture or an acquisition

– Deployment of surplus funds to generate income

Finance/Investment Company

Return on investment to generate profit

Risk diversification/reduction

Types of Investments

Long-term Investments

Investment in Fixed Assets

Investment in joint ventures

Market investments

– Equity Shares

– Bonds

– Mutual Funds/ Hedge Funds

Short-term Investments

Bank fixed deposits

Money market mutual funds

Concept of Risk

Risk is defined as uncertainty regarding the outcome of an event

For an investment or project, Risk can be visualised as to how

much does the returns or profits or cash flows deviate from

expected

Therefore, Risk is normally measured as the ‘standard deviation’

of actual returns from its mean or expected value

For a company, the business risk is the variability of the firm’s

earnings

An investment which is listed on the stock markets, it faces two

types of risks:

– Systematic Risk – Risk due to the whole stock market,

external to the company

– Unsystematic Risk – Risk due to factors specific to the

Company, unrelated to the markets

Concept of Return

Return is income received by an investor on an investment.

Rate of return is expressed as percentage of the principal

amount invested.

The amount of return on an investment is a function of three

things:

– Amount invested

– Length of time that amount is invested, and

– The rate of return on the investment

Rates of return are always quoted as annual rates

The formula for the annual rate of return is: Return received

for one year’s investment / Amount invested

9

What is The Time Value of

Money?

A dollar received today is worth more than a dollar received tomorrow

○ This is because a dollar received today can be invested to earn interest

○ The amount of interest earned depends on the rate of return that can be earned on the investment

Time value of money quantifies the value of a dollar through time

The Present Value is simply the

$1,000 you originally deposited.

That is the value today!

Present Value is the current value of a

future amount of money, or a series of

payments, evaluated at a given interest

rate.

Present value

What is the Present Value (PV) of the

previous problem?

11

Present Value of a Cash Flow

Stream

A cash flow stream is a finite set of payments that an investor will receive or invest over time.

The PV of the cash flow stream is equal to the sum of the present value of each of the individual cash flows in the stream.

The PV of a cash flow stream can also be found by taking the FV of the cash flow stream and discounting the lump sum at the appropriate discount rate for the appropriate number of periods.

12

Example of PV of a Cash

Flow Stream

Joe made an investment that will pay $100 the first year, $300

the second year, $500 the third year and $1000 the fourth

year. If the interest rate is ten percent, what is the present

value of this cash flow stream?

1. Draw a timeline:

0 1 2 3 4

?

$100 $300 $500 $1000

?

?

?

i = 10%

13

Example of PV of a Cash

Flow Stream

2. Write out the formula using symbols:

n

PV = S [CFt / (1+r)t] t=0

OR

PV = [CF1/(1+r)1]+[CF2/(1+r)2]+[CF3/(1+r)3]+[CF4/(1+r)4]

3. Substitute the appropriate numbers:

PV = [100/(1+.1)1]+[$300/(1+.1)2]+[500/(1+.1)3]+[1000/(1.1)4]

14

Example of PV of a Cash

Flow Stream

4. Solve for the present value:

PV = $90.91 + $247.93 + $375.66 + $683.01

PV = $1397.51

5. Check using a calculator:

○ Make sure to use the appropriate rate of return, number of

periods, and future value for each of the calculations. To

illustrate, for the first cash flow, you should enter FV=100, n=1,

i=10, PMT=0, PV=?. Note that you will have to do four separate

calculations.

Data Required for Investment

Evaluation

Investment in Machinery

Cash Outflow for investment

– Purchase value

– Installation cost

– In case of replacement, sale value of old equipment

Cash Inflow

– Annual cash Profit

– Adjusted for working capital increase or decreases

– Terminal salvage value

Financial Investments

– Investment cash outflow

– Annual interest/dividend

– Final market/redemption value

Discount Rate

– Cost of Capital

Key Issues

Only use relevant income and costs

Factors to consider

– Economic

– Industrial

– Firm wide inputs

Take due care in using historical performance as an indicator of

future performance

Consistently use either nominal or real earnings and expenses

Allocation of overheads should be down judiciously

Proper estimation of repairs and maintenance expenses

Capture life of project appropriately and account for salvage

value

Working capital requirements to be captured correctly, as

practicable

Cost of funding the project to take into account the firm’s cost of

capital

II. INVESTMENT EVALUATION

1. Project appraisal / Capital Budgeting

When do you use Capital

Budgeting?

When there is a limitation of capital

When decisions need to be taken on:

– Buying a new equipment

– Lease v/s purchase

– Undertaking an expansion project

– Cost reduction investment

– Decision to replace equipment now or later

– Enhance profitability

Capital budgeting process

– Identify projects

– Determine capital available

– Set-up hurdle rates or benchmarks

– Calculate project returns or profitability above threshold

– Rank projects as per selected criteria

– Select appropriate projects

How to Evaluate Capital

Investments

Payback Method

Measures the time required for a project to recover its initial cost

How to calculate Payback?

– Calculate Initial Investment and Annual Cash Inflows

– Cumulate Cash Flows

– Payback is the time taken for the cumulative cash flow to reach zero

indicating initial investment has been paid back

Rule of evaluation

– If Payback period is below hurdle period, accept the project

– If Payback period is above hurdle period, reject the project

Analysis of Payback Method

– Quick and easy to calculate

– Rough and ready indicator of risk

– However, does not consider time value of money

– Ignores cash inflow post the payback period

– Ignores cost of capital

Payback Method - Example

Estimate the Payback period for a project which calls for an initial

investment of $ 100,000 and an annual post tax cash flows of $ 30,000

for five years.

Answer:

– Roughly, payback period is between 3 and 4 years

– Accurately,

Payback Period = Beginning of gap year + (Gap to be covered) / Annual

cash flow in gap year

= 3 + 10,000 / 30,000 = 3.33 years

Net Present Value ‘NPV’

Method

NPV measures the cash flows of a project net of initial investment

– NPV = PV of Cash Inflows – Initial Investment

Rule of evaluation

– If NPV is positive, accept the project

– If NPV is negative, reject the project

What should be the discount rate that is to be used?

Overcomes some of the disadvantages of payback method:

– Considers time value of money

– Gives weightage to initial investment

Key Issues with NPV

– Gives an absolute numbers making it difficult to rank projects

NPV Method - Example

Estimate the NPV for a project which has the cash flows as per the

following table and using a discount rate of 10%

Answer:

NPV = PV of Cash Inflows – Initial Investment

= (18,182 + 28,296 + 37,566 + 40,981 + 46,569) – 100,000

= $ 72,223

Internal Rate of Return ‘IRR’

Method

Measures the rate of return of a project

Conceptually, IRR is the discount rate at which the NPV is zero

IRR can be calculated as the rate ‘r’ in the following equation

– Initial Investment = (CFt/(1+r)n)

Rule of evaluation

– If IRR is greater than hurdle rate, accept the project

– If IRR is lesser than hurdle rate, reject the project

IRR has issues which merit consideration

– Assumes intermediate cash flows are re-invested at the same rate as the

IRR

– Projects with alternating positive and negative cash flows can throw up

more than one IRR

To overcome the above issues with IRR, one can use Modified IRR

‘MIRR’

IRR Method - Example

Comparison between NPV &

IRR Methods

Accounting Return of Return

(ARR’) Method

ARR (also called Cost Benefit Method) is a ratio of the incremental net

income to the required investment.

It is calculated as follows:

Incremental annual average after tax (accounting net income) / Net initial

investment

This method uses accounting income and not cash flows

Advantage of the ARR is that it is easy to do and to understand

The disadvantages of ARR are:

– Does not incorporate the time value of money

– Focuses on operating income instead of cash flow

ARR Method - Example

How do you Rank Projects?

What if:

– NPV is higher for Project A but has lower IRR than Project B

– IRR of Project A is lower than threshold IRR but is of strategic

importance

– Two projects have positive NPV and IRRs higher than hurdle rate?

– Project A has a life of 12 years while Project B has a life of 6 years

Use concept of Profitability Index, ‘PI’ also called Benefit-Cost Ratio is

used to rank capital investment projects

PI is calculated as PV of Cash Inflows / Initial Investment

Rule of Evaluation

– Rule : If PI > 1, accept ; If PI < 1, Reject

Also useful method when there is a capital constraints

Ranking Projects - Example

The data for 3 projects are as under:

Question : If the Company had $ 175,000 to invest, which project or a

combination thereof would be undertaken?

Risk Analysis

Sensitivity Analysis

– Is a ‘What-if’ Technique

– Evaluates how the NPV, IRR, Payback change with change in

parameters such as discount rate, material costs, labor costs etc.

– Helps in planning for uncertainties

Scenario Analysis

– Uses single point estimates based on probability of scenarios of ‘best’,

‘worst’ or ‘most likely’

Simulation Analysis

– Simulation analysis computes the various outcomes if several variables

or assumptions change simultaneously.

Monte Carlo Analysis

– Based on computational algorithms which rely on random sampling

– Uses computerized simulations to generate hundreds of possible

outcomes

What should be the Hurdle

Rate?

Should be cost of capital

At times, opportunity cost/return may be used

Cost of capital is a function of:

– Capital structure and components

– Cost of each component of capital structure

– Riskiness of project

Cost of Capital is fluid and would change over time

Should you apply different hurdle rates for different type of projects?

Could there be conflicts between various funding sources?

Issues to consider

Discount Rates

– Companies typically use the weighted average cost of capital

– Could also use a desired long term rate of return

– Sometimes, opportunity cost

Project life

– Key consideration to evaluate cash flows

– Intermittent maintenance capex should be considered

– Don’t ignore salvage value at end of useful life

Initial Investment

– Consider all costs : equipment cost, shipping, commissioning

– If considering replacement, consider post tax salvage value of old

machine

Annual cash flows

– Adjusts for non cash charges, increases in working capital, tax

– All methods consider at of year cash flow for evaluation

– Ignore any intermediate funding/cash shortfalls

– Nominal or real cash flows?

Qualitative Considerations

Following qualitative factors could influence capital investment

decisions

– Lack of enough information to make capital investment decisions

– Firm may have self imposed capital rationing limits

– Loan provisions may limit borrowing and hence capital availability for

projects

– Decision makers may be risk averse

– Managers could have conflicts between taking new projects which might

affect their division performance in the near term

– Lack of sufficient qualified personnel to implement the project

Conflicts between Company

and Shareholders

2. Lease V/s purchase

Key Aspects of a Lease

Low upfront cost and regular annual cost

Ownership rests with lessor during the lease period

Post lease period, asset could be transferred to Lessee for a fee

Depreciation benefit claimed by Lessor

Off balance sheet item for Lessee

Normally, tax deductible expense for Lessee

Terms of lease would be a function of type of equipment

Typical terms include:

– Tenor which could be 5+ years

– Upfront fee which could include up to paying one instalment

– Lease interest is typically costlier than bank loans

– End of term transfer fee is nominal, could be linked to book value

Key Aspects of a Purchase

Ownership rests with the Company

Upfront cash outflow to the Company for the equipment

On balance sheet item for the Company

Depreciation benefit available to the Company

Depreciation and interest on loan taken to purchase are tax deductible

expense for the Company

Considerations for Lease v/s

Purchase Decision

Calculate Net Advantage of Leasing which compares

– Present value of cost of leasing the asset, and

– Present value of cost of owning the asset

If NAL is positive, then lease the asset

NAL is equal to

– Installed Cost of Asset

– Less : Present value of after tax lease payments (discount rate =

borrowing cost)

– Less : Present value of depreciation tax shield (discount rate =

borrowing cost)

– Add : Present value of after tax maintenance cost incurred, if

owned (discount rate = borrowing cost)

– Less : Present value of the after-tax salvage value (discount rate

= target rate of return)

Lease v/s Buy – An Example

Option to Lease or Purchase of USD 75 mn of new equipment

Lease terms

– Tenor : 5 years

– Lease rent : USD 280 per thousand

– After 5 years, transfer to Company at nominal salvage value

Purchase

– Depreciation rate : 20%

– Borrowing rate : 8%

– Target rate of return of the company : 10%

– Equipment would require annual maintenance cost of USD 2.0

million

– Tax rate : 30%

– Salvage Value = USD 5 million

Lease v/s Buy – An Example