Investment appraisal

Initial Investment components

the basic price of the capital project in Transportation and insurance charges. Installation costs License or Royalty Costs. Required additional working capital investment Operator training costs Any other cost represented by a cash outflow incurred only if the capital project is undertaken

Economic Life
Economic life otherwise known as Useful life is not necessarily the actual physical life. Determination of Economic life is based on
physical deterioration & technological obsolescence.

Cash Flow some more points

Application of any method of investment appraisal is primarily based on estimated future cash flows . Interest expenses excluded from cash costs as we assume that discount rate already include interest cost.

For simplicity of explanation we assume cash flows occur only at the end of a period and are not distributed through out the period.
Disposal of capital equipment may have an impact on paying additional taxes

Impact of frequency
Frequency of cash flow affects the present values of future cash flows.
Effective annual rate Annual Semi annual Monthly Yearly Continuous r (1+r/2)2-1 (1+r/12)12 - 1 (1+r/365)365- 1 er-1 Actual 10% 10% 10% 10% 10% Effective annual rate 10% 10.25% 10.47% 10.52% 10.52%

Cost of Capital
Cost of capital is the combined cost of debt and equity The cost of capital for each component in capital structure differs Thus capital structure determines the cost of capital

Arriving at free cash flow

TOTAL OPERATING INCOME ( TOI ) Sales Other operating income 1,000,000 10,000 1,010,000 TOTAL OPERATING EXPENSE ( TOE ) Raw Material Wages & Salaries Other Manufacturing expenses Selling & Distribution expenses Administrative expenses Depreciation 200,000 180,000 100,000 50,000 50,000 100,000 680,000

NET OPERATING INCOME ( NOI ) ( TOI - TOE )

330,000

NET OPERATING PROFIT AFTER TAX ( NOPAT) ( NOI x ( 1 - TAX RATE ) Assume 30% tax GROSS CASH FLOW ( NOPAT + Depreciation )
GROSS INVESTMENT Net Cash received Fixed Asset (addition) / disposal Working capital (increase) / decrease

231,000

911,000

(100,000) (80,000) 731,000

FREE CASH FLOW

( GROSS CASH FLOW - GROSS INVESTMENT )

Profit & Loss Account

Total Sales Less: Material cost Less: Variable O/h Less: Labor Less: Fixed o/h EBITDA Less: Depreciation EBIT Less: Finnce charges EBT 526,000 (424,500) (5,000) (80,000) (90,358) (73,858) (7,382) (81,239) (81,239)

Cash flow
EBT Add: Financ charges Add: Depreciation (81,239) 7,382 (73,858) (526,750) (600,608) (1,842,900) (2,443,508)

Working capital changes Cash from operations (Investments) Free Cash

Annuities
A constant cash flow occurring at regular intervals for a fixed period of time. Example:
Year
Annuity

1 1000

2 1000

3 1000

n 1000

1 1 (1 + r)n PV of an Annuity = PV(A,r, n) = A r

[A = Annuity; r = Discount Rate; n = Number of years]

Growing Annuity
A cash flow growing at constant rate for a specified period of time. Example:
Year 1 2 . . n

Annuity

1000 (1+g)

1000(1+g)2

1000(1+g)n

(1+ g) n 1 (1+ r)n PV of an Annuity = PV(A, r,g,n) = A(1 + g) (r - g)

[A = Annuity; r = Discount Rate; n = Number of years, g - growth]

Perpetuity
A constant cash flow at regular intervals for infinite period. Example:
Year Annuity 1 1000 2 1000 3 1000 4 1000 1000

A PV of Perpetuity = r
[A = Annuity; r = Discount Rate]

Growing Perpetuities
A cash flow that is expected to grow at a constant rate for an infinite period Example:
Year 1 2 . .

Annuity

1000 (1+g)

1000(1+g)2

1000(1+g)

CF1 PV of Growing Perpetuity = (r - g)

[CF1 = Cash flow next year; r = Discount Rate; g - growth]