ACCA PAPER F9

FINANCIAL MANAGEMENT LECTURE 2

INVESTMENT APPRAISAL
ROCE Payback Net present value Internal rate of return

CHAPTER 7

CAPITAL BUDGETING PROCESS

Capital expenditure is often expensive and requires careful analysis. The main stages in the capital budgeting process are:

ROCE

LECTURE EXAMPLE 1

RELEVANT CASH FLOWS

Only the cash flows affected by the decision to invest should be taken into account when appraising investments, these are called relevant costs. Only consider future, incremental cash flows Ignore:

sunk costs Committed costs Depreciation Interest & dividend payments

Include opportunity costs

RELEVANT CASH FLOWS

LECTURE EXAMPLE 2

PAYBACK
This is a measure of how many years it takes for the cash flows affected by the decision to invest to repay the cost of the original investment. A long payback period is considered risky because it relies on cash flows that are in the distant future.

PAYBACK

LECTURE EXAMPLE 3

CAPTURE SUMMARY

Capital Expenditure is often expensive and requires careful analysis.

Neither ROCE nor payback are adequate methods of appraising capital investments by themselves; the main problem with both methods is that they ignore the time value of money. Both methods are useful complements to the more sophisticated methods that are looked at in the next chapter.

CHAPTER 8

THE TIME VALUE OF MONEY

Money received today is worth more than the same sum received in the future because of: The potential for earning interest The impact of inflation The effect of risk Many projects involve investing money now and receiving returns on the investment in the future; so the timing of a projects cash flows need to be analysed to see if they offer a better return than the return an investor could get if they invested their money in other ways. The process of adjusting a projects cash flows to reflect the return that investors could get elsewhere is called discounting.

LECTURE EXAMPLE 1

COMPOUNDING

Compounding calculates the future value of a given sum of money FV = PV (1 + r)n where FV = future value after n periods PV = present or initial value r = rate of interest per period n = number of periods

DISCOUNTING

Discounting is the conversion of future cash flows to their present value

ANNUITIES AND PERPETUITIES

An annuity is a constant annual cash flow for a number of years

LECTURE EXAMPLE 2
1.

2.

What is the present value of $1,000 in contribution earned each year from years 1-10, when the required return on investment is 11%? What is the present value of $2,000 costs incurred each year from years 3-6 when the cost of capital is 5%?

ANNUITIES AND PERPETUITIES

An perpetuity is an annual cash flow that occurs for ever

LECTURE EXAMPLE 3
An organisation with a cost of capital of 14% is considering investing in a project costing $500,000. The project would yield nothing in Year 1, but from Year 2 would yield cash inflows of $100,000 per annum in perpetuity. Required Assess whether the project should be undertaken.

ANNUITIES AND PERPETUITIES

NET PRESENT VALUE

All future cash flows are discounted to their present value and then added A positive result indicates the project should be accepted A negative result and the project should be rejected

LECTURE EXAMPLE 4
A machine will cost $80,000 It has an expected life of 4 years with an anticipated scrap value of $10,000. Expected net operating cash inflows each year are as follows: 1.20,000 2.30,000 3.40,000 4.10,000 The cost of capital is 10% p.a. Calculate the Net Present Value of the investment and determine whether or not it should be accepted. what reservations might you have about your investment decision?

LECTURE EXAMPLE 5
LCH manufactures product X which it sells for $5 per unit. Variable costs of production are currently $3 per unit, fixed costs 50c per unit. A new machine is available which would cost $90,000 but which could be used to make product X for a variable cost of only $2.50 per unit. Fixed costs, however, would increase by $7,500 per annum as a direct result of purchasing the machine. The machine would have an expected life of 4 years and a resale value after that time of $10,000. Sales of product X are estimated to be 75,000 units per annum. LCH expects to earn at least 12% p.a. from its investments. Ignore taxation. You are required to decide whether LCH should purchase the machine.

INTERNAL RATE OF RETURN

One problem in practice with using a Discounted Cash Flow approach to investment appraisal is that it is virtually impossible to calculate accurately the Cost of Capital for a company. Because of the uncertainty regarding the Cost of Capital it would be useful to know the breakeven rate of interest i.e. the rate of interest at which the project would have an NPV of zero. he rate of interest at which the NPV of the project is zero is known as the Internal Rate of Return (IRR). In order to estimate the IRR, we calculate the NPV of the project at two different rates of interest and estimate a rate giving an NPV of zero assuming linearity.

INTERNAL RATE OF RETURN

3 Step Approach Step 1 calculate the NPV of the project at 5% If for example the NPV is +, we know that the project gives >5% return Step 2 calculate the project at 10% If for example the project is negative we know that the project gives <10% return Step 3 calculate the internal rate of return using the formula

INTERNAL RATE OF RETURN

The rate of interest (discount) at which the NPV = 0

LECTURE EXAMPLE 6
A company is trying to decide whether to buy a machine for $80,000 which will save costs of $20,000 per annum for 5 years and which will have a resale value of $10,000 at the end of year 5. If it is the companys policy to undertake projects only if they are expected to yield a DCF return of 10% or more, ascertain whether this project should be undertaken.

NPV OR IRR?
Both

NPV and IRR are superior methods for appraising investments compared to the techniques covered in the previous chapter because:
they account for the time value of money (unlike ROCE and payback) they focus on relevant cash flows (unlike ROCE) they look at the cash flows over the whole life of the project (unlike payback)

By

examining the advantages and disadvantages of IRR (NPV has the opposite pros and cons) as a DCF technique, it can be shown that NPV is the superior technique.

INTERNAL RATE OF RETURN

DISADVANTAGES OF IRR

NPV A BETTER TECHNIQUE

NPV does not have any of the problems of IRR. The role of IRR is to act as a tool for explaining the benefits of an investment to non-financial managers; it should not be used as the financial analysis used to justify the investment decision. This is not to say that NPV is perfect; like any financial technique, there is the danger that the non-financial benefits of an investment are ignored.

SUMMARY

Capital expenditure is often expensive and requires careful analysis .

Payback is a useful device for screening risky projects, but NPV is the best method for the financial analysis of a project. IRR is useful for explaining the benefits of a project to non- financial managers. ROCE is only useful for picturing how an investment might impact on a firms financial statements.

TUTORIAL
1.

2.

3.

4.

A machine will cost $45,000 and is expected to generate $8,000 for each of the following 8 years. he cost of capital is 15% p.a. Calculate the NPV of the investment. The cost of capital is 12% p.a. What is the present value of $20,000 first receivable in 4 years time and thereafter each year for a total of 10 years? A machine costs $100,000 and is expected to generate $12,000 p.a. in perpetuity. The cost of capital is 10% p.a. What is the NPV of the project? The rate of interest is 5%. p.a. What is the present value of $18,000 first receivable in 5 years time and thereafter annually in perpetuity?

TUTORIAL

For the project in Lecture Example 4:

a) b) c)

Calculate the NPV of the project at an interest rate of 15% Estimate the IRR of the project using your results from part (a) and from Example 4. Interpret the result of (b).

Exam Bank Question 11 - Mazen