MODULE 7 INVESTMENT CRITERIA

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MODULE 7INVESTMENT CRITERIA

• INVESTMENT APPRAISAL AND FINANCING DECISIONS

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OBJECTIVES

• Review key concepts from financial principles
• Define investment
• Identify key investment questions
• Review key accounting concepts
• Identify define 4 common investment criteria
• Compare utility of different criteria

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New key terms

• Time preference
• Payback period
• Net present value
• Internal rate of return
• Equivalent annuity

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Review of key concepts from financial principles

• Compound interest
• periodic, nominal, effective interest rates
• discounting
• present value P, future sum Sn, annuity
• annuity of P (capital recovery)
• P of annuity (capitalisation)
• annuity of Sn (sinking fund)
• Sn of annuity (capital accumulation)

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Review of principles (cont)

• compound interest
• formula for effective ie (1ip)n 1
• Inflation, Nominal Dollars and Constant Value
  Dollars
• Nominal and Real Interest Rates
• Taxation Effects
• Comparing Different Investments

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Investment defined

• Saving setting money aside - for consumption or
  investment (not investment)
• Investment foregoing present consumption for
  greater consumption in future

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5 Investment questions

• Relating to the investment
• Cash flow pattern? (size and timing)
• Overall profitability?
• Risk?
• Relating to investor
• Cash flow feasibility?
• Comparison with alternatives?

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Review of key accounting concepts

• Three financial statements needed to give
  complete picture of state of a business
• Cashflow
• shows all cash inflows outflows, measures
  liquidity
• Profit Loss
• incorporates some non-cash items (examples?),
• excludes some cash items (examples?)
• shows profitability, not liquidity - Why?
• Balance Sheet
• shows assets, liabilities and equity

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Problems revealed by statements

• Lack of liquidity - cash deficit?
• Lack of profit, despite adequate liquidity?
• Low or Negative equity (LgtA)?
• Lender concerns about the business
• has adequate cashflow
• is inherently profitable
• has adequate assets for security

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Comparing Accounting statements with Investment
appraisals

• Financial accounting has historical perspective
• Investment appraisal is forward looking
• One year cashflow statement tells nothing about
  capital resources, need PL and B/S to complete
  the picture
• BUT projected cashflows (capital and revenue)
  over entire project life, including establishment
  costs and final sale of assets combines all
  necessary information

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• Accordingly, investment appraisal is usually
  based on analysis of cashflows over life of
  project
• can assess both short term liquidity and
  long-term profitability
• limitations relate to accuracy of projections,
  not capacity of cashflow to tell the whole story
• Methods to be outlined all based on project
  cashflow

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Investment criteria

• Three investment questions for a particular
  project
• cashflow feasibility (cash in gt cash out)
• economic profitability ( return on capital)
• desirability in comparison to other investments,
  ethicality.
• Classic tradeoff between investment objectives
• profitability vs risk

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Traditional investment criteria

• Initial assumptions
• 0 tax, 0 inflation, 0 borrowings (all funds
  equity funds)
• yr 0 now, yr 1 end year 1, yr 2 end year
  2..
• costs (outflows) shown in brackets

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1. Payback period

• simplest one of most widely used
• calculates time taken to recoup initial
  investment
• assumes early payback better than later (why?)

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Payback questions

• acceptable time - 2, 3, 5, . years?
• Many industrial projects use 5, less in unstable
  situations
• Agricultural projects rarely lt 5 yrs
• Choice between mutually exclusive projects (take
  shortest payback)

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Payback period 3 yrs Choose F, followed by A or
C But which of these offers the best financial
returns?
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Features of payback period as investment criterion

• Simplicity
• inherent conservatism
• ignores cashflows outside payback period
• cashflow timing ignored
• cant discriminate on project scale

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Opportunity cost, time preference, discounting

• Money has an opportunity cost
• spending 1 now means I cannot invest it and have
  gt 1 in the future
• 100 now is better than (preferrable to) 105 in
  one year, if interest rates are 10, 0 inflation
• but 100 now is inferior to 115 in 1 yr, _at_ 10
  interest
• 100 now is equivalent to 110 in 1 yr, the
  rational person is indifferent between the 2
  alternatives
• use compounding discounting to compare present
  future values

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Opportunity cost of money

• 19th Century Interest is the rental cost of
  using borrowed capital
• early 20th Century interest is the factor
  balancing S D of funds, interest rate
  determinants are more complex than rental cost
  only
• government policy also affects interest rates
• positive rate of time preference for money (most
  people prefer 1 now to 1 later)
• declining marginal utility of money
• uncertainty regarding the future
• myopia, consumption focus.
• Choosing appropriate discount rate is contentious

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Interest rate, opportunity cost, inflation, and
choice of discount rate

• Inflation reduces purchasing power of a fixed sum
  over time
• lenders need higher interest rate
• borrowers will pay higher interest when inflation
  increases
• people have a real rate of time preference (even
  with 0 inflation, prefer 1 now to 1 later)
• therefore, discounting future to present
  values has 2 possible components
• inflation
• time preference

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Dealing with values over time

• Be consistent in dealing with inflation
• if cash flow is in nominal , then use nominal
  discount rate
• if cash flow is in real terms, use lower discount
  rates, allowing only for time preference

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Discounting criteria

• Discounted Payback Period
• Net Present Value (NPV)
• Internal Rate of Return (IRR)

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Discounted Payback Period

• Same as payback period, but cashflows are
  discounted to present values
• Pros cons
• allows for timing of cashflows, through
  discounting
• indicates when a project becomes worthwhile, if
  discount rate interest rate
• more complex than payback period

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Net Present Value

• NPV sum of discounted benefits minus sum of
  discounted costs
• Decision rules
• choose project with highest NPV (for mutually
  exclusive projects)
• accept all projects, not mutually exclusive, with
  positive NPV, to limit of funds available

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4 components of NPV

• Initial cash outflow
• Net cash inflows
• Investment lifespan
• Cost of capital (market rate of interest for
  projects of similar risk profile)

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Internal Rate of Return

• Rate of interest (discount) at which NPV 0
• Method involves trial error
• 1. guess IRR
• 2. calculate NPV using this discount rate
• 3. recalculate using 3-5 higher rate if NPV is
  positive, or 3-5 lower if NPV is negative
• 4. continue until there are both ve and -ve
  values for NPV, 3-5 apart
• 5. Graph or guesstimate the rate where NPV0
• 6. Abandon tedious hand calculations, use a
  spreadsheet, get answer accurate to several
  decimal places

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Internal Rate of Return

• 5. Graph or guesstimate the rate where NPV0
• Use approximating formula

IRR lower discount rate (rate difference
(positive NPV/absolute value both NPVs))
7. Abandon tedious hand calculations, use a
spreadsheet, get answer accurate to several
decimal places
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Use formula IRR 20(5 (10/11)) 24.54
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• Alternative definitions of IRR
• rate of return earned on capital after recouping
  original investment
• the rate of return earned by the investment
• the maximum rate of interest that could be paid
  if total capital borrowed

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Attributes of IRR

• Provides a measure of return on capital
• does not require a decision about appropriate
  discount rate
• may be easier to understand than NPV
• cant be calculated if cashflow is positive in
  every year (IRRinfinity)
• doesnt account for scale or timing

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Comparison between NPV and IRR

• No clear answer on which is best?
• Accept/reject situations
• NPV - accept if NPV ve
• IRR - accept if IRR gt cost of capital
• Mutually exclusive projects
• IRR may be misleading because no account of scale
  (accept high return, low capital, low NPV
  project, and lose out on higher NPV, but lower
  IRR project)
• IRR discriminates against longer time frame
  projects
• Other factors risk, liquidity, non-financial
  objectives

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Cash flow calculation

• Consistent cashflow (annuity)
• over several years
• Can shortcut the discounting process using
  Present Value of Annuity (which is the sum of
  individual discount factors for all the years)
• This gives the value of the annuity as at the end
  of the year BEFORE it starts
• It must then be discounted to Yr 0
• e.g. p.102, annuity yrs 3-10 annuity for 8 yrs,
  find PV of A for 8 yrs, discount back to Yr0
  using 2yr discount factor

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Cash flow calculation

• 2. Project life
• (a) Steady state cashflow after establishment
  provides equivalent of annuity indefinitely
• annuity to infinity can be valued (capitalised)
• C A/i
• As for PV of A, relates to (located in) the year
  preceding the start of annuity

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Cash flow calculation

• Project life
• (b) Not realistic to assume indefinite life
• impose termination date eg at 10, 15, 20 yrs - 15
  yrs works well
• assume remaining assets sold at this date,
  salvage value included in yr 15 cashflows

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3. Equivalent annuities

• Converting an NPV
• (single lump sum equivalent)
• to an annuity equivalent
• (annual cashflow stream)
• Process
• Take NPV and convert to annuity using Annuity of
  Present Value table

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Concept of equivalent annuity

• Converting a variable cash flow stream into an
  average annual cash flow, after allowing for time
  preference
• useful for comparing annual with perennial crops
  e.g lucerne hay vs grain, tree crops vs small
  crops

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Conclusion

• We have
• Reviewed key concepts from financial principles
• Defined investment
• Identified key investment questions
• Reviewed key accounting concepts
• Defined concept of Time preference
• Identified defined 4 common investment criteria
• Compared utility of different criteria

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4 common investment criteria

• Payback period
• Net present value
• Internal rate of return
• Equivalent annuity