Capital Investment Appraisal

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Presentation covers detailed account of Capital Budgeting techniques along with their decision mechanism.

Presentation covers detailed account of Capital Budgeting techniques along with their decision mechanism.

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  • 1. Presentation byFCMA, FPA, MA (Economics), BSc Dubai, United Arab Emirates
  • 2. Learning Objectives 2
  • 3. Background Knowledge Investment – Refers to an outlay of funds on which management expects a return. An investment creates value for its owners when the expected returns from the investment exceed its cost. Capital expenditure– Refers to long-term commitments of resources that provide future benefits. Spending by a business to acquire fixed assets (e.g., property, plant, equipment, machinery, vehicles), research and development, massive market campaigns, acquisition and take-over of other Cos., etc. Why invest? – Businesses need to invest in order to grow. – They might want to increase capacity so they can produce more.– They could also look to invest to increase the efficiency of their operations. 3
  • 4. Definition & Utility Capital Investment Appraisal (CIA) refers to the complete process of generating/initiating investment proposals, evaluating, ranking and selecting the best alternative(s) and making follow up on investment(s) made. CIA techniques aim to assess the financial feasibility of investment options. CIA looks at, how an investment opportunity is worthwhile and how it fits to the company strategy and goals??? CIA is used for all types of investment from the purchase of a new piece of machinery to a whole factory!!! CIA allows investment managers to make an informed choice regarding the viability and acceptability of a project. 4
  • 5. Relevant Concepts Independent investments are projects that can be accepted or rejected regardless of the action taken on any other investment, now or later. Mutually exclusive investments are projects that preclude one another, acceptance of one project means automatic rejection of the other or vice versa. There are two types of mutually exclusive and independent investments – replacements and investments in new product and processes. 5
  • 6. Nature & Importance Nature Long-term rather than short-term. Large investment rather than small investment. More complicated from concerns of future cash flows and/or time value of money. Irreversible in the normal course. Importance Large amount of resources are involved that has impact on business strategy, profitability, and survival. Difficult to “bail out”, once an investment made. The capital investments are challenging and critical to the success of the company. An incorrect decision may end with the company’s closing-out from the market. Close relationship with shareholders for their approval. 6
  • 7. CIA ProcessCIA is a five steps process normally followed by the investmentmanagers in the manner given as below: Initiating, generating and gathering investments ideas. Analyzing the costs and benefits for proposed investments by: – Forecasting costs and benefits for each investment. – Evaluating the costs and benefits based on CIA techniques. Ranking the relative superiority of each investment alternative based on financial performance worked out and choosing the best investment opportunity from the given set of opportunities. Implementing the investment alternative chosen. Making follow-up on the investment made on regular basis to see how far this investment opportunity has been effective in the given framework of the company to achieve its desired objectives. 7
  • 8. CIA TechniquesA: Traditional Techniques 1. Payback period (PB) 2. Accounting Rate of Return (ARR)B: Discounted Cash Flow (DCF)/ Time Adjusted (TA) Techniques 1. Net Present Value (NPV) 2. Internal Rate of Return (IRR) 3. Modified Internal Rate of Return (MIRR) 4. Terminal Value (TV) 5. Profitability Index (PI) or Benefit/Cost Ratio Important Note: These techniques provide theoretically reliable evaluation under conditions of perfect certainty. They are, nevertheless, widely used in practice in the face of uncertainty. 8
  • 9. CIA Techniques NPVPB IRRARR MIRR TV PI or B/C Ratio 9
  • 10. Non-financial Factors Company Goodwill, Image & Reputation– You may reject an investment opportunity, as it will reflect badly on the company goodwill, image and reputation!!!!!! Company Policies, Objectives & Culture– You have to check, if the investment conforms to the policies, objectives and culture of the company???? Environmental, Social, Legal & Ethical Issues – Is the investment under consideration, environmentally, socially andethically acceptable and viable????? There might be legal implications for some investment opportunities. Impact on Stakeholder Relationships – What is the impact of the investment on competitors, shareholders,employees, buyers, bankers, suppliers and government institutions, etc.,??? 10
  • 11. Analyzing Strategic Position for Business Growth & Investment Business Strength High Medium LowMarket Attractiveness Build gradually Build aggressively Build aggressively High – improve & – invest & grow – invest & grow defend Build aggressively Build gradually Medium Divest – invest & grow – improve & defend Build gradually Low Divest Divest – improve & defend 11
  • 12. An Illustrative ModelThere are two mutually exclusive projects A and B for theconsideration of XYZ company. The data for the initialinvestments and subsequent cash inflows is given on the nextslide.Calculate:– PB, ARR– NPV, IRR, MIRR, TV, & PIImportant note: This is a very simple model, where initial cash outlays(net investments),project lives, total of cash inflows over the entire lives, residual values at the end of the projects,interest rates, depreciation charges and tax rates for the projects are all same. There is no furtherinvestment after the initial one for the two investing opportunities. Moreover, the projects A and Bhave continuous stream of cash inflows during the entire period related to them. 12
  • 13. Cash Flows for Projects A & B Project A: Net Cash flows Project B: Net Cash flows in/(out) in/(out) Year For the year Accumulated For the year Accumulated AED. AED. AED. AED. 0 (100,000) (100,000) (100,000) (100,000) 1 45,000 (55,000) 30,000 (70,000) 2 40,000 (15,000) 30,000 (40,000) 3 35,000 20,000 44,000 4,000 4 50,000 70,000 66,000 70,000 The depreciation charge is AED. 20,000 per annum. The residual value for both projects is the same, AED. 20,000 Interest rate is 10% per annum All cash inflows are net-off tax 13
  • 14. 1. PB Calculation Payback period for Project A= (change in cash flow required to reach zero/total cash flow in the year) + complete years= (15,000/35,000) + 2= 0.43 + 2 years = 2.43 years Payback period for Project B= (40,000/44,000) + 2= 0.91 + 2 years = 2.91 years Decision Rules Project A has recovered the initial investment in 2.43 year whereas Project B hasrecovered initial investment in 2.91 years. Project A has recovered initialinvestment earlier than Project B, therefore Project A is SELECTED.Important note: A variation of this technique that involves Present Values of cash inflows is knownas Discounted Payback Period. It gives exact idea of recouping of original investment to the business. 14
  • 15. 2. ARR Calculation Process : Calculate annual profit Annual profit = net cash inflow - depreciation : Calculate average profit Average profit = total profits / number of years : Calculate average capital invested Average capital invested = (initial cost + residual value) /2 : Calculate ARR ARR = Average profit/average capital invested x 100 15
  • 16. ARR CalculationProject AAverage profit = (25,000+20,000+15,000+10,000)/4 = 70,000/4 = 17,500Average capital invested = (100,000+20,000) /2 = 60,000ARR = 17,500/60,000 x 100 = 29%Project BAverage profit = (10,000 + 10,000 + 24,000 + 26,000)/4 = 17,500Average capital invested = (100,000 + 20,000)/2 = 60,000ARR = 17,500/60,000 x 100 = 29%Decision RulesThe Project that has higher ARR is selected. In this case both projects have sameARR. Therefore, results from other techniques shall lead us to final decision. 16
  • 17. Time Value of Money What is the difference between AED. 1 received now and AED.1 received in a year’s time???AED.1 received now has more value than that is received after a year!!! The factors that change the value of money over a given period of time are given as below: – Interest cost – Inflation – Other risks to materialise the money For example The annual interest rate is 10%, I lend you AED. 1 now and will get back after 1 year, how much worth of that AED.1 in a year’s time? ? x (1+10%) = AED. 1 ? = AED. 0.909 10% is called “cost of capital”; “?” is called the “discount factor” 17
  • 18. 3. NPV Calculation The XYZ company’s interest rate is 10% p.a. Discount Factors @ 10% p.a. for AED. 1 are as given below: Year 1 = 0.909 Year 2 = 0.826 Year 3 = 0.751 Year 4 = 0.683 Formula to calculate Discount Factor @ 10% p.a. for AED. 1 is given as follows: Discount Factor = 1/(1+10%)^n 18
  • 19. NPV Working for Project A Discount Net Cash Present Factor for Project A flows in Value in AED.1 @ AED. AED. 10% p.a. Year 1 2 3=1x2 0 (100,000) 1.000 (100,000) 1 45,000 0.909 40,905 2 40,000 0.826 33,040 3 35,000 0.751 26,285 4 50,000 0.683 34,150 NPV 34,380 19
  • 20. NPV Working for Project B Discount Cash Present Factor for Project B flow in Value in AED. 1 @ AED. AED. 10% p.a. Year 1 2 3=1x2 0 (100,000) 1.000 (100,000) 1 30,000 0.909 27,270 2 30,000 0.826 24,780 3 44,000 0.751 33,044 4 66,000 0.683 45,078 NPV 30,172 20
  • 21. NPV Decision Rules 21
  • 22. 4. IRR CalculationIRR is the discount rate which delivers a zero NPV for a given project.Project ANPV = AED. 34,380 when the discount rate is 10%NPV = ? When the discount rate is 25% Discount Factor Present Cash flow Project A for AED. 1 @ Value in in AED. 25% p.a. AED. Year 1 2 3=1x2 0 (100,000) 1.000 (100,000) 1 45,000 0.800 36,000 2 40,000 0.640 25,600 3 35,000 0.512 17,920 4 50,000 0.410 20,500 NPV (20) 22
  • 23. IRR WorkingProject BNPV = AED. 30,172 when the discount rate is 10%NPV = ? When the discount rate is 25% Cash flow in Discount Factor for Present Value in Project A AED. AED. 1 @ 25% p.a. AED. Year 1 2 3 = 1x2 0 (100,000) 1.000 (100,000) 1 30,000 0.800 24,000 2 30,000 0.640 19,200 3 44,000 0.512 22,528 4 66,000 0.410 27,060 NPV (7,212) 23
  • 24. IRR Decision RulesProject A: IRR = 25%Project B:Total change in NPV = 30,172 – (– 7,212) = 37,384Total change in discount rate = 25% – 10% = 15%IRR = 10% + 30,172/37,384 x 15% = 22%Decision ruleFor the two mutually exclusive projects A and B, following rule shall be applied:If Project A’s IRR>Project B’s IRR then select Project A , &If Project B’s IRR>Project A’s IRR then select Project BIn this case Project A’s IRR>Project B’s IRR, therefore, Project A is selected. 24
  • 25. 5. MIRR CalculationMIRR is used to gauge an investment’s attractiveness. It is employed torank alternative investments of equal size. There are mainly two problemsof IRR that are resolved by MIRR.I. IRR assumes that interim positive cash flows are re-invested at the same rate of return as that of the project that generated them. This is usually an un- realistic scenario and more likely situation is that the funds will be re- invested at a rate closer to the company’s cost of capital. IRR, therefore, often gives an unduly optimistic picture of the projects being examined. Generally, for comparing projects more fairly, Weighted Average Cost of Capital (WACC) should be used for re-investing the interim cash flows.II. More than one IRR can be found for projects with alternative positive and negative cash flows, which leads to confusion and ambiguity. MIRR finds only one value. 25
  • 26. MIRR Formula MIRR can be calculated by using Excel Formula that is given as below: = MIRR(range, finance_rate, reivestment_rate)Where:Range: is the range of cells that represent a project’s cash flowsFinance_rate: is the interest rate that company pay’s to its banksReinvestment_rate: is the rate that company expects to receive on reinvestment of cash inflows 26
  • 27. MIRR Decision Rules Calculation According to the data given at slide 13, Cost of Capital for the Project A and B is same at10% p.a. According to the assumption used in the formula for MIRR, the minimum returnon re-invested cash inflows is equal to Cost of Capital or Weighted Average Cost of Capital (WACC) instead of IRR of the given projects. MIRR for Project A = MIRR(range, 10%, 10%) = 18.44% MIRR for Project B = MIRR(range, 10%, 10%) = 17.50% Decision Rules In case of independent projects, the project having MIRR greater than Cost of Capital is acceptable. For mutually exclusive projects, the project having higher MIRR shall be selected. Conclusion Project A has higher MIRR than that of Project B. Therefore, A should be selectedaccording to the criteria established for acceptance and rejection of projects under MIRR. 27
  • 28. 6. Terminal Value Calculation At the end of year Expected rate of return (%) 1 7 2 9 3 6 4 8 28
  • 29. Terminal Value Working Total Total Net cash Net cash compounded compoundedYr. RoI YuI CF inflows inflows for sum for sum for Project A Project B Project A Project B1 2 3 4 5 6=4x5 7 8=4x7 % AED. AED. AED. AED.1 7 3 1.225 45,000 55,125 30,000 36,7502 9 2 1.188 40,000 47,520 30,000 35,6403 6 1 1.060 35,000 37,100 44,000 46,6404 8 0 - 50,000 50,000 66,000 66,000 Total 170,000 189,745 170,000 185,030 Abbreviations used in the table: RoI: Rate of Interest expected from the market (minimum expected rate can be used) YuI: Years under investment CF: Compounding factor based on given rates Yr.: Year 29
  • 30. Terminal Value Results Now, we can calculate the Present Value of the compounded sums for Project A and Project B in the following manner:Project A compounded sum x PV factor @ 10% = AED. 189,745 x 0.683 Present Value for Project A compounded sum = AED. 129, 596Project B compounded sum x PV factor @ 10% = AED. 185,030 x 0.683 Present Value for Project B compounded sum = AED. 126,375 Important NoteA variation of Terminal Value (TV) is based on the pattern of NPV technique and is known as Net Terminal Value (NTV) technique. Symbolically, NTV = PVTS – PVO. It has the same DecisionRules that are used for NPV technique. If NTV is positive accept the project and if it is negative then reject it. 30
  • 31. Terminal Value Decision Rules Decision RulesFor single project, If the Present Value of the Total of compounded re-invested cash inflows (PVTS) is greater than the Present Value of the Outflows (PVO), the proposed project is accepted, otherwise not.For multiple projects (mutually exclusive projects), the project having PVTS greater than all competing projects when compared with PVOs relating to them, shall be selected. Symbolically, PVTS>PVO Accept PVTS<PVO Reject Conclusion In both projects PVTS is greater than PVO. Since we have to select any one of them, that is Project A because its PVTS is greater than Project B when both compared with their PVO which is same in this case. 31
  • 32. 7. Profitability Index Calculation Profitability Index (PI) or Benefit/Cost Ratio (B/C Ratio) measures Present Value per Dirham invested.It is a ratio of PV of future cash inflows by PV of cash outlays (ie net investment). PI = PV of expected cash inflows /PV of cash outflowsIn keeping with the ongoing illustration, we calculate here PI for Projects A & B. PI for Project A = 134,380/100,000 = 1.344 PI for Project B = 130,172/100,000 = 1.302 32
  • 33. Profitability Index Decision Rules Decision RulesIf the PI for any single project exceeds 1, the project can be accepted. For the mutually exclusive projects, the project that has higher PI should be considered for investment. ConclusionIn the given illustration of two Projects A and B, Project A has higher PI than that of Project B. Management can take up Project A for the proposed investment opportunities. 33
  • 34. Decision Rules for all CIA Techniques Accept or Reject Criteria for …# Tech. Single or Independent Project(s) Mutually Exclusive Projects1. PB Less than the Target Period Shortest payback period2. ARR Above the Target Rate With the highest ARR3. NPV A positive NPV With the highest NPV4. IRR Higher than the Target Rate (Cost of Capital) With the highest IRR5. MIRR Higher than Target Cost of Capital (i.e. WACC) With higher MIRR If PVTS>PVO Accept,6. TV With the highest PVTS>PVO And if PVTS<PVO Reject7. PI (B/C Ratio) PI exceeding 1 Higher PI 34
  • 35. Summary of Results from all CIA Techniques Results for Mutually Exclusive Projects… Accept Project# Technique A B A or B?1. PB 2.43 years 2.91 years A2. ARR 29% 29% N/A3. NPV AED. 34,380 AED. 30,172 A4. IRR 25% 22% A5. MIRR 18.44% 17.50% A6. TV AED. 129,596 AED. 126, 375 A7. PI (B/C Ratio) 1.344 1.302 A 35
  • 36. Merits & Demerits of Traditional Techniques# Tech. Merits Demerits  Simple and easy to understand and use.  Objective – using cash flows.  Ignores the time value of  Liquidity – commercially realistic. money.1. PB  Cautious & risk averse – ignores later cash flows.  Ignores cash flows after the  First level estimator – gives rough idea payback period. about the recouping of the investment.  Subjective – profit, not cash  Simple and easy to understand and use. flows.  Aids internal and external  Ignores the time value of comparisons. money.2. ARR  Looks at the whole life of the project.  Difficulty in use when with  A useful tool to measure divisional same ARR and various managerial performance. project sizes. 36
  • 37. Merits & Demerits of DCF Techniques# Tech. Merits Demerits  Takes account of the time value of  Difficult to be understood by managers. money.  Adverse effects on accounting profits in  Instrumental in maximization of the short run. shareholder wealth.  How to choose discount rate?1. NPV  Takes account of risk.  May not give satisfactory results where  Looks at total benefits over the projects have different lives. whole life of the project.  In case the projects have different cash  Particularly useful for mutually outlays, it may not give dependable exclusive projects. results.  Takes account of the time value of  Involves tedious calculations. money.  Difficult to use in choosing projects of2. IRR  Easy to be understood by managers. varying sizes.  Takes into account total cash  Difficult to choose when have the same inflows and outflows. IRR. 37
  • 38. Merits & Demerits of DCF Techniques# Tech. Merits Demerits  There is much confusion about the  Quicker to calculate than IRR. reinvestment rate used in this formula.  MIRR is invariably lower than  One implication of MIRR is that the3. MIRR IRR that may be due to more project may not generate cash flows as realistic assumption about re- predicted and that NPV of the project is investment rate. overstated.  Explicitly uses re-investment of cash inflows.  The major weakness of this  Mathematically easier. technique that it utilizes interest4. TV  Easier to understand than NPV or rates that are uncertain for future IRR. cash inflows.  It suits better to cash budgeting.  In mutually exclusive projects NPV  Better technique than NPV in5. PI situations where capital rationing appears to be superior technique than (B/C Ratio) PI. issues are involved.  Difficult to understand. 38
  • 39. Abbreviations Used# Abbreviation Complete word1 AED. UAE Dirham2 ARR Accounting Rate of Return3 CIA Capital Investment Appraisal4 DCF Discounted Cash Flow5 IRR Internal Rate of Return6 MIRR Modified Internal Rate of Return7 NPV Net Present Value8 NTV Net Terminal Value9 PB Payback Period10 PI Profitability Index (also known as B/C Ratio)11 PVO Present Value of Cash Outflows12 PVTS PV of Total Compounded Reinvested Cash inflows 39
  • 40. Capital Rationing The management has not only to determine the profitable investmentopportunities, but it has also to decide about that combination of projects which delivers highest NPV within the available funds. There are two types of capital rationing.  External Capital Rationing -- Factors that are outside the company due to financial market conditions.  Internal Capital Rationing -- Factors that are within the company due to policy, procedure or other constraints. 40
  • 41. Questions &Answers 41
  • 42. Thank you!Presentation byAhmad Tariq BhattiFCMA, FPA, MA (Eco.), BSc.Mobile #: 00971-50-2024143Email id: at.bhatty@gmail.comDubai, United Arab Emirates 42