Module 6 Investment Decisions Part I: longterm investment decision

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Module 6 Investment DecisionsPart I
long-term investment decision
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What is Financial Management?

• Financial management is concerned with making
  decisions in three key areas
• What investments should the business take on?
• THE INVESTMENT DECISION
• How can finance be obtained to pay for the
  required investments?
• THE FINANCING DECISION
• Should business profits be paid as dividends to
  shareholders or be reinvested in the business?
• THE OPERATING or DIVIDEND DECISION

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Investment Decision

• Long-term investment decision (capital
  budgeting) purchasing assets expected to
  generate revenue in the long term
• Current investment decision (managing current
  assets) supporting the trading of the business

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Long-term Investment Decision

• Also known as capital budgeting decision, which
  involves the planning (including funding),
  evaluation and selection of proposals for
  investment in no-current assets. e.g
• Maintenance Projects
• Cost Savings/Revenue Enhancement
• Capacity Expansions in Current Business
• New Products and New Businesses

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Capital Expenditure Process

• The capital expenditure process involves
• generation of investment proposals
• evaluation and selection of those proposals
• approval and control of capital expenditures
• post-completion audit of investment projects

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Evaluation and Selection of Investment Proposals

• To enable evaluation of a proposal it should
  include the following data
• brief description of the proposal
• statement as to why it is desirable or necessary
• estimate of the amount and timing of the cash
  outlays
• estimate of the amount and timing of the cash
  inflows
• estimate of when the proposal will come into
  operation
• estimate of proposals economic life

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Types of Projects

• A conventional project is one that has an initial
  cash outflow, followed by one more more expected
  future net cash inflows.
• Buying a stock or bond.
• A non-conventional project may have several net
  cash outflows and inflows.
• Some net cash outflows may occur in the future.
• For example, an environmental clean up cost at
  the end of a project or a major overhaul during
  the projects life.

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Types of Projects

• Two projects are independent if undertaking one
  does not affect the other. But the limitation is
  the fund available in the company.
• Two projects are mutually exclusive if
  undertaking one precludes taking the other, even
  though other projects may be acceptable in terms
  of the decision rules for independent selection.

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Methods of Project Evaluation and Selection

• Methods of project evaluation include
• Discounted cash flow methods
• Those methods that involve the process of
  discounting a series of future net cash flows to
  their present values
• net present value (NPV)
• internal rate of return (IRR)
• benefitcost ratio (profitability index)
• Non-discounted cash flow methods
• payback period
• accounting rate of return

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Discounted Cash Flow MethodsNet Present Value
(NPV)

• Difference between the PV of the net cash flows
  (NCF ) from an investment, discounted at the
  required rate of return, and the initial
  investment outlay.
• Measuring a projects net cash flows
• forecast expected net profit from project, making
  an adjustment for non-cash flow items
• Or estimate net cash flows directly

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Calculation of NPV

• where
• C0 initial cash outlay on project
• Ct net cash flow generated by project at
  time t
• n life of the project
• k required rate of return

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Net Cash Flow

• Cash inflows
• receipts from sale of goods and services
• receipts from sale of physical assets
• Cash outflows
• expenditure on materials, labour, and indirect
  expenses for manufacturing
• selling and administrative
• inventory and taxes

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Evaluation of NPV

• Decision rule for NPV method
• Accept a project if its net present value is
  positive when the projects net cash flows are
  discounted at the required rate of return.

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NPV Illustrated
0
1
2
Initial outlay
Revenues
2000
Revenues
1000
(1100)
Expenses
1000
Expenses
500
500
Cash flow
1000
Cash flow
1100.00
1
500
x
1.10
454.55
1
1000
x
1.10
2

826.45
NPV

181.00
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Internal Rate of Return (IRR)

• Discount rate that equates the present value of a
  projects net cash flows with its initial cash
  outlay that is, the discount rate at which the
  net present value is zero.
• The IRR is compared to the required rate of
  return (k ). If IRR gt k the project should be
  accepted.

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Calculation of InternalRate of Return

• where
• C0 initial cash outlay on project
• Ct net cash flow generated by project at
  time t
• n life of the project
• r the internal rate of return

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ExampleIRR
Initial investment 200


Year Cash flow

1
50

2
100

3
150
Find the IRR such that NPV 0
n

50
100 150

0 200


(1IRR)
1
(1IRR)
2
(1IRR)
3

50

100 150


200

(1IRR)
(1IRR)
(1IRR)
1
2
3
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ExampleIRR (continued)
Trial and Error


Discount rates
NPV

0
100

5
68

10
41

15
18

20
2
IRR is just under 20about
19.44
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Problems with IRR

• More than one negative cash flow
  (non-conventional) project ? multiple rates of
  return.
• Project is not independent ? mutually exclusive
  investments. Highest IRR does not indicate the
  best project.

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Multiple Rates of Return
Assume you are considering a project for
which the cash flows are as follows

Year
Cash flows

0
252

1
1431

2
3035

3
2850

4
1000
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Multiple Rates of Return
Whats the IRR? Find the rate at which
n
the computed NPV 0

at 25.00
NPV
0

at 33.33
NPV
0

at 42.86
NPV
0

at 66.67
NPV
0
Two questions
n
1.
Whats going on here?
u
2.
How many IRRs can there be?
u
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Multiple Rates of Return
NPV
0.06
0.04
IRR 25
0.02
0.00
(0.02)
IRR 33.33
IRR 66.67
IRR 42.86
(0.04)
(0.06)
(0.08)
0.2
0.28
0.36
0.44
0.52
0.6
0.68
Discount rate
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IRR, NPV and Mutually-exclusive Projects

• The NPV and IRR methods will both provide the
  same accept or reject decision for independent
  projects .
• That is, projects that have a positive NPV will
  also have an IRR greater than the cost of
  capital.
• For mutually exclusively projects, there is a
  conflict sometimes occurs between the two methods
  due to the timing and magnitude of the cash flows.

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Ps Cost of capital of 12 is used for estimating
NPV
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IRR, NPV and Mutually-exclusive Projects
Net present value



Project X

project Y
0
Crossover Point
Discount rate
2
0
6
10
14
18
22
26
IRR
IRR
x
x

y
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Choosing Between the Discounted Cash Flow Methods

• Independent Investments
• For independent investments, both the IRR and NPV
  methods lead to the same accept/reject decision,
  except for those investments where the cash flow
  patterns result in either multiple or no internal
  rate of return.

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Choosing Between the Discounted Cash Flow Methods

• Evaluating Mutually Exclusive Projects
• NPV and IRR methods can provide different ranking
  order.
• The NPV method is the superior method for
  mutually exclusive projects.
• Ranking should be based on the magnitude of NPV.

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Benefit-Cost Ratio(Profitability Index)

• Index calculated by dividing the present value of
  the future net cash flows by the initial cash
  outlay
• Benefit-cost ratio
• Decision rule
• accept if benefitcost ratio gt 1
• reject if benefitcost ratio lt 1

present value of net cash flows initial cash
outlay
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Other Methods of Project Evaluation

• There are two major non-discounted cash flow
  methods that are used
• Payback Period Method
• Accounting Rate of Return Method

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Payback Period

• The time it takes for the initial cash outlay on
  a project to be recovered from the projects
  after-tax net cash flows.
• Decision
• Compare payback to some maximum acceptable
  payback period.
• What length of time represents the correct
  payback period as a standard against which to
  measure the acceptability of a particular project?

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Payback Period Illustrated
Initial investment 1000

Year
Cash flow

1
200

2
400

3
600

Accumulated
Year
Cash flow

1
200

2
600
1200

3
Payback period
2
400/600 22/3 years
Assume the prescribed maximum payback period is 3
years, so accept this project
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Payback Period (cont.)

• Popular because
• it is simple to apply
• provides information on how long funds are
  committed to a project
• Weaknesses
• it fails to account for the magnitude and timing
  of all the projects cash flows

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Accounting Rate of Return (ARR)

• Earnings (after depreciation and tax) from a
  project expressed as a percentage of the
  investment outlay.
• The calculation involves
• estimating the average annual earnings to be
  generated by the project
• investment outlay (initial or average)

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Accounting Rate of Return (ARR)

• A project is accepted if ARR gt target average
  accounting return.

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ExampleARR


Year

1
2 3
Sales
440
240
160
Expenses
220
120
80
Gross profit
220
120
80
Depreciation
80
80
80
Taxable income
140
40
0
Taxes (25)
35
10
0
Net profit
105
30
0
Assume initial investment 240
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ExampleARR (continued)
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ExampleARR (continued)
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Accounting Rate of Return

• Fundamental problems of ARR as a basis for
  project evaluation
• arbitrary measure based on accounting profit as
  opposed to cash flows
• ignores timing of the earnings stream

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Application of Project Evaluation Methods

• Practical project evaluation has to accommodate
• uncertainty with respect to the cash flows
• uncertainty with respect to the estimation of the
  projects required rate of return
• the existence of taxes

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Application of the Net Present Value Method

• Estimation of cash flows in project evaluation
• Focus on incremental cash flows
• Is it a cash item? E.g. depreciation?
• Will the amount of the item change if the project
  is undertaken? (opportunity cost)
• Exclude sunk costs
• Costs already incurred are irrelevant to future
  decision making.
• Decisions on whether to continue a project should
  be based only on expected future costs and
  benefits.

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Application of the Net Present Value Method
(cont.)

• Estimation of cash flows in project evaluation
• Beware of allocated costs
• Any costs that will not change as a result of the
  project should be excluded from the analysis.
• Exclude financing charges
• The required rate of return used to discount cash
  flows incorporates the cost of equity and debt.
  Including financing charges in the cash flows
  would be double counting.

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Application of the Net Present Value Method
(cont.)

• Estimation of cash flows in project evaluation
• Include residual values
• This will provide a cash flow at end of project.
• Consistency in the treatment of inflation
• Estimate cash flows based on anticipated prices,
  and discount the cash flows using a nominal rate
  or
• Estimate cash flows without adjusting them for
  anticipated price changes, and discount the cash
  flows using a real rate.

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• Assume an investment of 1000 is expected to
  generate cash flows of 500, at constant prices
  at the end of each of 3 years. Assume also that
  prices are expected to increase at he rate of 10
  per cent per annum and that the nominal required
  rate of return is 15 per annum. What is the
  projects net present value?

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Depreciation

• The depreciation expense used for capital
  budgeting should be the depreciation schedule
  required for tax purposes.
• Depreciation itself is a non-cash expense
  consequently, it is only relevant because it
  affects taxes.
• Prime cost vs diminishing value methods
• Depreciation tax shield DT
• -D depreciation expense
• -T marginal tax rate

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Disposal of Assets

• If the salvage value gt book value, a profit/gain
  is made on disposal. This profit/gain is subject
  to tax (excess depreciation in previous periods).
• If the salvage value lt book value, the ensuing
  loss on disposal is a tax deduction (insufficient
  depreciation in previous periods).

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Application of the Net Present Value Method
(cont.)

• Estimation of cash flows in project evaluation
• Recognise the timing of the cash flows
• Just as in the valuation of debt securities such
  as bonds, the exact timing of cash flows can
  affect the valuation of an investment project.
• A simplifying assumption is that net cash flows
  are received at the end of a period.
• Example 6.2 textbook p.149

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Investment Evaluation

• Step 1 Calculate the taxable income.
• Step 2 Calculate the cash flows.
• Step 3 Discount the cash flows.
• Step 4 Decision.

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ExampleInvestment Evaluation

• Purchase price 42 000
• Salvage value 1000 at end of Year 3
• Net cash flows Year 1 31 000
• Year 2 25 000
• Year 3 20 000
• Tax rate is 30
• Depreciation 20 reducing balance
• Required rate of return 12

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SolutionDepreciation Schedule
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SolutionTaxable Income
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SolutionCash Flows
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SolutionNPV and Decision
Decision NPV gt 0, therefore ACCEPT.
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ExampleReplacement DecisionIncremental Cash
Flows
A firm is currently considering replacing a
machine purchased two years ago with an original
estimated useful life of five years. The
replacement machine has an economic life of three
years. Other relevant data is summarised below
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SolutionTaxable Income
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SolutionCash Flows
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SolutionNPV and Decision
Decision NPV lt 0, therefore REJECT.
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Projects with different lives

• One project may end before the other.
• How to compare?
• Assume that the company will reinvest in a
  project identical to that currently being
  analysed Constant Chain of Replacement
  Assumption.
• Make assumptions about the reinvestment
  opportunities that will become available in the
  future.

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Constant Chain of Replacement Assumption

• Each project is assumed to be replaced at the end
  of its economic life by an identical project.
• Valid comparison only when chains are of equal
  length.
• This can be achieved by
• lowest common multiple method (LCM)
• equivalent annual value method (EAV)

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The firm is considering investing in either
project A or B, which have the following net cash
flows. Assuming r 10
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• NPV(A) -2000024000xPVF(10,1)
• 1818
• NPV(B) -2000010000xPVF(10,3)
• 4868
• Compare project A and B by assuming that project
  A was repeated until project B had ended. So, the
  cash flow of project A can be as follows

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Equivalent Annual Value Method (EAV)

• What amount, to be received each year for n
  years, is equivalent to receiving the net present
  value of a project whose life is n years?
• The project with the higher EAV is preferred to
  the project with the lower EAV.

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Example Unequal lives

• Project A costs 3000 and then 1000 per annum
  for the next four years.
• Project B costs 6000 and then 1200 for the next
  eight years.
• Required rate of return for both projects is 10
  per cent.
• Which is the better project?

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SolutionProject A
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SolutionProject B
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SolutionInterpretation

• Project A is better because it costs 1946 per
  year compared to Project Bs 2325 per year.

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Retirement decisions

• Retirement Decisions
• Situations where assets are used for some time,
  and then it is decided not to continue the
  operation in which the assets are used.
  Therefore, the assets are sold and not replaced.

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Retirement Decisions

• Want to determine, during the life of a project,
  whether the project is still worthwhile.
• NPV rule is the appropriate tool for retirement
  decisions.
• A project should be retired if the NPV of all its
  future net cash flows is less than zero.

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Example Retirement Decisions

• Mortlake Ltd owns a 6-year-old machine.
• The required rate of return is 10 per cent when
  should the machine be retired?
• PV of retiring now is 12 000.
• Maintaining machine will provide cash flows need
  to calculate NPV at ends of year 7 and 8.

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Example Retirement Decisions (cont.)