NATURE AND STAGES OF INVESTMENT APPRAISAL
Nature
- Replacement Investment
- Investment for Expansion
- Product Improvement/Cost Reduction
- New Ventures
- Strategic Investment – may satisfy overall objectives but might not satisfy normal financial criteria.
- Statutory Requirements/Employee or Community Welfare – may not produce a positive NPV but may be essential.
Stages
Identification.
Ideas may generate from all levels of the organisation. Initial screening may reject those that are unsuitable – technically/too risky/cost/incompatible with company objectives etc. The remainder are investigated in greater depth – assumptions required regarding sales, costs etc./collect relevant data. Also consider alternative methods of completing projects.
Evaluation
Identification of expected incremental cash flows. Measure against some agreed criteria – Payback/Accounting Rate of Return/Net Present Value/Internal Rate of Return. Consider effect of different assumptions – Sensitivity Analysis or other techniques. Consultation with other interested parties (particularly if great organisational and/or technological change) – accountants/production staff/marketing staff/trade unions etc.
Authorisation
Submit to appropriate management level for approval/rejection/modification. The larger the expenditure, the higher the management level. Reappraise investment – reassess assumptions and cash flows (e.g. check for any “bias” in estimates)/evaluate how investment fits within corporate strategy and capital constraints (if any). If budgetary or other constraints exist, rank as to how essential (financial and nonfinancial considerations).
Monitor & Control
Regularly review to ascertain if any major variations from cash flow estimates. If significant variations – consider continuation v abandonment. Post audits (one or two years after implementation!) are useful – encourage more realistic estimates at evaluation stage/help to learn from past mistakes/basis for corrective action to existing investments.
INVESTMENT APPRAISAL TECHNIQUES
There are many techniques for evaluating investment proposals. These can be broadly classified as:
Non-Discounting
Payback Period
Accounting Rate of Return (ARR)
Discounted Cash Flow
Net Present Value (NPV)
Internal Rate of Return (IRR)
Payback Period
Definition: The time taken in years for the project to recover the initial investment.
The shorter the payback, the more valuable the investment.
Example
An initial investment of RWF50,000 in a project is expected to yield the following cash flows:
Cash Flow
| Year 1 | RWF20,000 |
| Year 2 | RWF15,000 |
| Year 3 | RWF10,000 |
| Year 4 | RWF10,000 |
| Year 5 | RWF8,000 |
| Year 6 | RWF5,000 |
The Payback Period is 3 1/2 years – the cash inflows for that period equal the initial outlay of RWF50,000.
Is 3 1/2 years acceptable? – It must be compared to the target which management has set. For example, if all projects are required to payback within, say, 4 years this project is acceptable; if the target payback is 3 years then it is not acceptable.
Although of limited use it is the most popular technique.
It is often used in conjunction with other techniques.
It may be used as an initial screening device.
Advantages
- Calculation is
- It is easily understood
- It gives an indication of
- It gives a measure of risk – later cash flows are more uncertain.
- It considers cash flow rather than profit – profit is more easily manipulated.
Disadvantages
- Cash flows after the Payback Period are ignored.
- It ignores the timing of the cash flows (“Time Value of Money”).
- No clear decision is given in an accept/reject situation.
Accounting Rate of Return (ARR)
Definition:
Average Annual Accounting Profits
ARR = = %
Initial Investment
(Alternative definitions may be used occasionally – e.g. „Average Investment‟ may replace
„Initial Investment‟).
The Accounting Rate of Return is based upon accounting profits, not cash flows.
Advantages
- Calculation is simple.
- It is based upon profits, which is what the shareholders see reported in the annual accounts.
- It provides a % measure, which is more easily understood by some people.
- It looks at the entire life of the project.
Disadvantages
- It is a crude averaging method.
- It does not take account of the timing of the profits.
- It is based on accounting profit which can be manipulated by creative accounting. Shareholders‟ wealth is determined by cash. Varied Definitions are used.
Discounted Cash Flow (DCF)
The main shortcomings of the non-discounting techniques of Investment Appraisal can be summarised as:
- They do not allow for the timing of the cash flows/accounting profits
- They do not evaluate cash flows after the payback period
- They do not allow for the changing value of money over a medium to long term
Discounted Cash Flow addresses these shortcomings, by allowing for the “time-value of money” and looking at all cash flows. So what is discounting? Discounting can be regarded as Compound Interest in reverse.
The compounding and discounting features shown above relate to single payments or receipts at different points in time. Similar calculations can be done for a series of cash flows, where a single present value can be calculated by aggregating the present value of several future cash flows.
ANNUITIES
An annuity is where there is a series of cash flows of the same amount over a number of years.
The present value of an annuity can be found by discounting the cash flows individually
Net Present Value (NPV)
This technique converts future cash flows to a common point in time (Present Value), by discounting them. The present values of the individual cash flows are aggregated to arrive at the Net Present Value (NPV).
The NPV figure represents the change in shareholders’ wealth from accepting the project. It produces an absolute value (RWF) and therefore, the impact of the project is identified.
For independent projects the decision rule is:
Accept if the NPV is positive
Reject if the NPV is negative
For mutually exclusive projects (where it is only possible to select one of many choices) – calculate the NPV of each project and select the one with the highest NPV.
In calculating the NPV, the selection of a discount rate is vitally important. It is generally taken as the cost to the business of long-term funds used to fund the project.
Advantages
- Correctly accounts for the time value of money.
- Uses all cash flows.
- Is an absolute measure of the increase in wealth
- Consistent with the idea of maximising shareholder wealth i.e. telling managers to maximise NPV is equivalent to telling them to maximise shareholder wealth.
- It can be used for benchmarking in post-audit review.
Disadvantages
- Difficult to estimate cost of capital.
- Not easily interpreted by management i.e. managers untrained in finance often have difficulty in understanding the meaning of a NPV.
Internal Rate of Return (IRR)
The NPV method produces an absolute value in currency (RWF). A positive NPV indicates that the project earns more than the required rate of return and should be accepted; a negative NPV indicates a return less than the required rate and rejection of the proposal.
The IRR is another discounted cash flow technique. It produces a percentage return or yield, rather than an absolute value. It is the discount rate at which the NPV would be zero – where the present value of the outflows = present value of the inflows. It can, therefore, be regarded as the expected earning rate of the investment.
If the IRR exceeds the company’s target rate of return it should be accepted. If less than the target rate of return it should be rejected.
The IRR can be estimated by a technique called ‘Linear Interpolation‟. This requires the following steps:
- Calculate two NPV’s, using two different discount rates.
- Any two rates can be used but, ideally, one calculation will produce a positive NPV and the other a negative
- Choosing the discount rate is a ‘shot in the dark.’ However, if the first attempt produces a positive NPV, generally a higher discount rate will be required to produce a negative NPV and vice versa.
Advantages
- Often gives the same decision rule as NPV.
- More easily understood than NPV.
- Doesn‟t require an exact definition of “r” in advance.
- Considers the time value of money.
- Considers all relevant cash flows over a project‟s life.
Disadvantages
- Relative, not absolute return -> ignores the relative size of investments.
- If there is a change in the sign of the cash flow pattern, one can have multiple IRR‟s.
- NPV is much easier to use for benchmarking purposes in a post-audit situation than IRR.
- It looks at projects individually – the results cannot be aggregated. It cannot cope with interest rate changes.
DCF Techniques v Non-DCF Techniques
DCF techniques have advantages over non-DCF techniques:
They allow for the ‘time value of money.’
They use cash flows, which result from an investment decision. The ARR technique is affected by accounting conventions (e.g. depreciation, deferred expenditure etc.) and can be susceptible to manipulation.
They take account of all cash flows. The Payback Period disregards cash flows after the payback period.
Risk can be easily incorporated by adjusting the discount rate (NPV) or cut-off rate (IRR).
Advantages of IRR Compared To NPV
It gives a percentage rate or return, which may be more easily understood by some.
To calculate the IRR it is not necessary to know in advance the required rate of return or discount rate, as it would be to calculate the NPV.
Advantages of NPV Compared To IRR
It gives an absolute measure of profitability (RWF) and hence, shows immediately the change in shareholders’ wealth. This is consistent with the objective of shareholder wealth maximisation. The IRR method, on the other hand, ignores the relative size of investments.
It always gives only one solution. The IRR can give multiple answers for projects with nonconventional cash flows (a number of outflows occur at different times).
It always gives the correct ranking for mutually exclusive projects, whereas the IRR technique may give conflicting rankings.
Changes in interest rates over time can easily be incorporated into NPV calculations but not IRR calculations.
RELEVANT CASH FLOWS
In an examination question you will be given much information regarding the impact on the organisation of a new investment proposal etc. Some of the information may not be relevant to the decision and it is important that you are able to figure out which flows are relevant and should be included in an investment appraisal calculation.
For example, suppose you were asked to evaluate whether a U.K. organisation should establish a subsidiary in the USA and the following paragraph appeared halfway through the question:
„…The company currently exports to the USA, yielding an after-tax net cash flow of GBP100,000. No production will be exported to the USA if the subsidiary is established. It is expected that new export markets of a similar worth in Southern Europe could replace exports to the USA. Home production is at full capacity and there are no plans for further expansion in capacity‟.
This lengthy paragraph is, obviously, designed to confuse you. If we analyse it further we find that it is merely saying that the organisation currently exports GBP100,000 worth of goods to the USA which will be replaced by GBP100,000 of new exports to Southern Europe, if we establish the subsidiary. Thus, it has a neutral impact on our decision and can be omitted from the appraisal.
The following pointers and simple examples should assist in coping with the various items which are presented to you in an examination:
CASH FLOWS v PROFITS
Shareholders‟ wealth is based upon the movement of cash. Accounting policies and conventions have no effect on the value of the firm and, thus, pure accounting or book entries should be excluded from calculations. The most common of these is depreciation, which should be excluded as it is a non-cash item.
Example
A company is considering investing in a new project which requires the expenditure of RWF12m. immediately on plant. The project will last for 5 years and at the end of the project the plant is expected to have a scrap value of RWF2m. The company normally depreciates plant over 5 years using the straight-line method.
In this simple illustration the last sentence concerning depreciation can be ignored completely as it does not affect the cash flows. It would be incorrect to show an outflow of RWF2m p.a. for depreciation. The relevant cash flows are the outflow of RWF12m. on plant in year 0 and the inflow of RWF2m as scrap in year 5.
CASH FLOWS SHOULD BE INCREMENTAL
The effect of a decision on the company‟s overall cash flows must be considered in order to determine correctly the changes in shareholders‟ wealth.
OVERHEADS
Variable overheads will always be relevant in decision making. However, depending on the situation fixed overheads may or may not be relevant. If fixed overheads are allocated on some arbitrary basis (e.g. on the basis of machine or labour hours) they are not usually relevant. However, if the total fixed costs of the organisation are affected by the proposal then they are relevant and should be incorporated as a cash flow.
To produce the new product the organisation can utilise factory space which is currently idle. No additional factory rental costs will be incurred by the company and it would be incorrect to show an annual cash outflow of RWF25,000 (one-quarter) in respect of rent when evaluating the new proposal.
On the other hand, the additional warehouse rent of RWF20,000 per annum is incurred solely as a result of the new proposal and must be taken into account in the evaluation process.
SUNK COSTS
Sunk costs (or past costs) are costs which have already been incurred. When making an investment decision sunk costs can be ignored and you need only consider future incremental cash flows.
OPPORTUNITY COSTS
The use of resources for a new project may divert them from existing projects, thereby causing opportunity costs. These opportunity costs must be taken into account in evaluating any new project.
INTEREST COSTS
In many examination questions you will be presented with all the costs of the proposed project. These may be presented in the form of a standard Profit & Loss Account. One of these costs may be „Interest.‟ The figure for interest should not be included as a relevant cost because the cost of finance, no matter what its source, is encompassed within the discount rate. Therefore, to include the annual interest charge as a relevant cost and to also discount the cash flows would result in double counting.
WORKING CAPITAL
Where the project requires an investment of, say RWF50,000, for working capital it should be remembered that working capital revolves around continuously in the project (e.g. purchase of raw materials, which are used to manufacture goods, sold and eventually generate cash to enable the purchase of more raw materials etc.. and continuously repeat the cycle). Thus, the RWF50,000 flows back into the organisation once the project ceases. In this example, if the project has a life of five years the cash flows relating to working capital are:
