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Capital Investment Analysis

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Capital Investment Analysis

Also called Capital Budgeting - a complex topic simplified in an easy to understand presentation which is completely self-explanatory. Explains the framework for financial analysis with examples and provides practical insights. Can be used for reference, training & self paced learning. The presentation includes examples worked in an Excel sheet.

Covers:
* The nature & characteristics of long term investments made by corporations
* The problem associated with measuring the rate of return with long term investments
* The approach to solving this problem
* The key methods used in calculating the rate of return and evaluating alternatives
* The practical aspects of the various inputs required to calculate the return on investment
* The basics of the risks associated with long term investments & how to factor ?in such risks
* The strategic considerations involved in long term investment decisions
* The processes involved in long term investment decisions & its implementation

Published in: Business, Economy & Finance
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  • 1. Capital Investment Analysis Also called Capital Budgeting - a complex topic simplified in an easy to understand presentation which is completely self-explanatory. Explains the framework for financial analysis with examples and provides practical insights. Can be used for reference, training & self paced learning. The presentation includes examples worked in an Excel sheet.
  • 2. What is Capital Budgeting (CB)? The nature & characteristics of long term investments made by corporations
  • 3. Capital Budgeting? Business looking to grow take decisions on • New products • New Markets • New production facilities • New technology • Market share etc. This involves investment of funds in • R&D • Capacity increase • Buying new technology • Buying new companies, brands etc. Such investments need to be evaluated because • Large outlays are involved initially • Returns come by way of cash flows in future Capital budgeting is the process of evaluation of specific investment (also called capital expenditure) proposals. ‘Capital’ refers to the funds that needs to be invested i.e. the assets to be bought/created using the funds, which in turn would contribute to the growth/competitiveness. ‘Budgeting’ refers to the estimation of the funds that may be required initially and also the estimation of cash flows that the assts so procured will generate in the future.
  • 4. CB – Importance • Capital expenditure or Capex represents the growing edge of a business and is also needed to maintain competitiveness. • Future profits & its growth depends upon the return new capital investment generate and is under the constant scrutiny of the market. • The need for a business to earn a sufficient rate of return on its investment (ROI) over and above its cost of funds is well understood. • One of the key responsibility of the management is to ensure that all future capex also generate adequate return to maintain and improve the market standing of the firm.
  • 5. Capital Budgeting – The Problem The problem associated with measuring the rate of return with long term investments
  • 6. • In general whenever a capital investment is made • there will be a large funds outflow during a period • followed by a stream of cash in flows as the investment starts generating revenues • The business hopes that the inflows will repay the initial investment and also provide an adequate surplus. • The problem is how to relate the immediate cash out-flow with a stream of future in-flows. Let us address this issue…. CB – The Problem
  • 7. CB – The Problem Time Period Investment Return 0 Payment Out 1 + 2 + 3 + 4 + 5 + Time Period Investment B ($) Return ($) 0 -1000 1 +200 2 +200 3 +200 4 +200 5 +1200 Total 2000 How do we compare a future stream with a present lump sum? How to calculate the ROI? Investment repayment is done in one lump sum at the end of the period together with the last interest payment ($1000+$200) Fixed Income Security patterns of returns, interest, repayments easily identified.
  • 8. CB – The Problem Time Period Investment Return 0 Payment Out 1 + 2 + 3 + 4 + 5 + Time Period Investment A ($) Return ($) 0 -1000 1 +300 2 +400 3 +600 4 +500 5 +200 Total 2000 How do we compare a future stream with a present lump sum? How to calculate the ROI? In commercial investment repayment is not done in one lump sum at the end of the period - it is spread over a number of years.
  • 9. • Also we all know that money received in a distant time in the future is not worth the value of money today. • This concept is also popularly known as ‘Time Value of Money’. • Due to this we cannot compare sums of money or cash flows that fall in different time periods. • To compare we need a mechanism where all the value of money/cash flows can be expressed at one specific time period. • The period selected usually is Period 0. • Let us now understand how to do this. CB – The Problem
  • 10. CB – Approach Time Period Investment Return 0 Payment Out 1 + 2 + 3 + 4 + 5 + Each item in the stream of payments is to be brought back to today’s value. These separate amounts when totaled to give a single lump sum that can be compared with the investment lump sum.Total Return in today’s money then can be compared with the initial investment made.
  • 11. CB – Approach Time Period Investment ($) @10% P.A. Future Value (FV) ($) 0 100 1 100(1+10/100)1 = 100x1.1 110 A = P(1+r/100)n Future Value - Principal + Interest at the end of year 1 P= Principal (Amount Invested) r = Interest rate per period n = Number of years (or number of periods) A = Amount at the end of the period n This is the well known compound Interest formula which is taught at the school level. Thus FV at the end of Period 2 = 100(1.1)2 Period 3 = 100(1.1)3 Period 4 = 100(1.1)4 Period 5 = 100(1.1)5
  • 12. CB – Approach Thus FV at the end of Period 1 = 100(1.1) = 100 x 1.1 Period 2 = 100(1.1)2 = 100 x 1.210 Period 3 = 100(1.1)3 = 100 x 1.331 Period 4 = 100(1.1)4 = 100 x 1.464 Period 5 = 100(1.1)5 = 100 x 1.611…… Thus PV if investment and interest realised at the end of Period 1 = 100/(1.1) = 100x(0.909) Period 2 = 100/(1.1)2 = 100x(0.826) Period 3 = 100/(1.1)3 = 100x(0.751) Period 4 = 100/(1.1)4 = 100x(0.683) Period 5 = 100/(1.1)5 = 100x(0.621)…… Future Value or Compounding Interest Rate Factors Present Value or Discounting Interest Rate Factors
  • 13. Present Value Time Period Investment ($) Return ($) PV factor @10% PV ($) 0 5000 1 1500 0.909 1364 2 3500 0.826 2893 3 1400 0.751 1052 Total 5309 This is the expected initial outflow towards the capital investment in time period 0 These are expected value of cash inflows at the end of subsequent periods – here period assumed to be one year These are the PV factors which when we multiply with the cash inflow values we get the PV of the cash inflows. Total PV of the cash inflows expected in the future periods.
  • 14. Net Present Value Time Period Investment ($) Return ($) PV factor @10% PV ($) 0 5000 1 1500 0.909 1364 2 3500 0.826 2893 3 1400 0.751 1052 Total 5309 We now have two numbers that can compared directly NPV = $5309 – $5000 = $309 The concept of Net Present Value is introduced here which the difference between the PV of the cash flows in future periods and the cash flow today
  • 15. Time Period Investment ($) Return ($) PV factor @10% PV ($) 0 5309 1 1500 0.909 1364 2 3500 0.826 2893 3 1400 0.751 1052 Total 5309 This means the cash flows give a return of 10% p.a. exactly. Therefore with an investment of less than $5309 if we get the same cash inflows, then the return must be higher than 10% p.a. Net Present Value
  • 16. Ti me Per iod Investment ($) Return ($) PV factor @10% PV ($) 0 5309 1 1500 0.909 1364 2 3500 0.826 2893 3 1400 0.751 1052 Total 5309 This means the cash flows give a return of 10% p.a. exactly. Therefore with an investment of than $5309 we get the same cash inflows than the return must be higher than 10% p.a. NPV = $5309 – $5000 = $309 NPV = $5309 – $5309 = 0 A positive NPV means that the project is likely to deliver a rate of return greater than the interest rate being used in the calculations (the hurdle rate) and vice versa. ROI =10% ROI >10% Net Present Value
  • 17. Time Period Investment ($) Return ($) PV factor @10% PV ($) 0 5000 1 1500 0.909 1364 2 3500 0.826 2893 3 1400 0.751 1052 Total 5309 We know that the return is greater than 10%...but what is the return? For this let us first determine the PV of future cash flows at 11%. Time Period Investment ($) Return ($) PV factor @11% PV ($) 0 5000 1 1500 0.901 1351 2 3500 0.812 2841 3 1400 0.731 1024 Total 5216 Internal Rate of Return (IRR)
  • 18. Interest Rate % PV ($) Investment ($) NPV ($) 10 5309 5000 309 11 5216 5000 216 12 5126 5000 126 13 5039 5000 39 14 4954 5000 -46 15 4871 5000 -129 NPV would be 0 some where between 13 & 14%. ?? This rate is the IRR of the project. The project is selected for further evaluation if IRR is equal to or greater than the hurdle rate decided by the management. We carry out this exercise with different increasing rates. Internal Rate of Return (IRR)
  • 19. CB Inputs – The Practical Aspects The practical aspects of the various inputs required to calculate the return on investment
  • 20. • Capital Investment • Consider only the incremental cash outlay i.e. total additional cash flows that could result from doing the project as against not doing it. • Factor-in any savings arising from operational synergies, tax etc. • Include additional working capital (such as inventories) that may be required to support the investment. • Do not include any allocated cost i.e. costs that are transferred from other parts of the firm which does not result in any additional cash outflow. CB Inputs – Practical Aspects
  • 21. • Life of the Project • This can be based on project’s physical, technological or economic life span. • Computers even if physical exist can be outdated in two to three years. • Similarly transport vehicles may exist physically even after 5 years but cost of maintaining and running them may not be economical etc. • The estimated saleable value of the assets at the end of the period is called the Terminal Value and considered as a cash inflow in the DCF model. CB Inputs – Practical Aspects
  • 22. • NPV and IRR are interrelated frameworks popularly called discounted cash flow methods or DCF methods of project appraisal. • Once the mathematical framework is understood than the real challenge is in estimating and providing the model the right inputs. • Needless to say as inputs are related to the future, the numbers are best estimates of the management based on their past experience and the knowledge of the industry. • The managements will therefore test a series of scenarios by varying the input factors and see the sensitivity of the key outputs to it. CB Inputs – Summary
  • 23. • Simple Products Inc. is contemplating a new investment project, the details of which are given below. • Project outlay : $ 200 mn. out of which $120 mn. is to be spent on fixed assets with rest ($80 mn.) on gross working capital. The entire investment will happen at one shot at the beginning of the project. • Funding : Equity capital = $ 80 mn., Long term debt i.e. debentures = $ 60 mn. @ 6.5% p.a. Short term bank borrowings = $ 40 mn. @ 5% p.a. Trade Credit = $20 mn. • Project life : 5 years. Salvage value of fixed assets is estimated at $ 40 mn. Liquidation value of working capital will be equal to its book value = $80 mn. CB Inputs – Example 1
  • 24. • Solution CB Inputs – Example 1 • Gross WC – (ST bank Loan +Trade Credit) • $80mn. – ($40mn.+$20mn.) = $20mn. Working Capital Margin • Fixed Assets + Net WC = $120mn. + $20mn. = $140mn. Another way to look at it is….. • Equity Capital + LT Loans = $80mn. + $60mn. = $140 mn. Long Term Funds Invested • Investment in Fixed Assets + Working Capital marginInitial Flow
  • 25. • Solution CB Inputs – Example 1 • Initial Flow + Operating Flow +Terminal Flow Net Cash Flow • Net Salvage Value of FA + Net recovery of WC margin = $40mn. + $20mn. = $60mn. Terminal Cash Flow • Profit After Tax + Depreciation - for each of the 5 years Operating Cash Flows
  • 26. $ mn. Year 0 1 2 3 4 5 Fixed Assets -120 Working capital margin -20 Revenues 100 100 100 100 100 Exp. (excl. depreciation & Interest) 60 60 60 60 60 Depreciation 12 10 8 6 5 Profit before tax 28 30 32 34 35 Tax 10 11 11 12 12 Profit after tax (PAT) 18 20 21 22 23 Net salvage value of fixed assets 40 Net recovery of work. cap margin 20 Initial flow -140 Operating flow 30 30 29 28 28 Terminal flow 60 Net cash flow -140 30 30 29 28 88 CB Inputs – Example 1 Operating Flow = Profit after tax + Depreciation (Note that Interest is excluded and after tax cash flows are considered). • Solution
  • 27. Year In $ mn. 0 1 2 3 4 5 Fixed Assets -120 Working capital margin -20 Revenues 100 100 100 100 100 Exp. (excl. depreciation & Interest) 60 60 60 60 60 Depreciation 12 10 8 6 5 Profit before tax 28 30 32 34 35 Tax 10 11 11 12 12 Profit after tax (PAT) 18 20 21 22 23 Net salvage value of fixed assets 40 Net recovery of work. cap margin 20 Initial flow -140 Operating flow 30 30 29 28 28 Terminal flow 60 Net cash flow -140 30 30 29 28 88 Net cash Flow = Initial Flow + Operating Flow + Terminal Flow CB Inputs – Example 1 • Solution
  • 28. CB Inputs – Example 1 $ mn. Year 0 1 2 3 4 5 Initial flow -140 Operating flow 30 30 29 28 28 Terminal flow 60 Net cash flow (A) -140 30 30 29 28 88 • Solution – NPV & IRR PV factor @12% (B) 1.0000 0.8929 0.7972 0.7118 0.6355 0.5674 PV of cash Flows (A)x(B) -140 27 24 21 18 50 NPV (Sum of PV of cash Flows) -1 IRR (Use Excel IRR function) 11.77% Project will be rejected as the NPV is negative/IRR is lower than the required rate of return.
  • 29. • Depreciation is charged on both the new and old plants at 20% as per WDV (written down value) method. • The new automated plant is expected to result in an annual saving of $10mn. in manufacturing costs. Investment in working capital would remain unaffected. The tax rate applicable is 35%. With the above information, work out the incremental post- tax cash-flows associated with this project. If the minimum required rate of return is 15% p.a. calculate the NPV. What is the IRR of the project? CB Inputs – Example 2
  • 30. CB Inputs – Example 2 $mn. Year 0 1 2 3 4 5 Net investment in plant -40 Savings in manufacturing costs 10 10 10 10 10 Depreciation on old plant (1) 2 2 1 1 1 Depreciation on new plant (2) 10 8 6 5 4 Incremental Depreciation on new plant (2 minus 1) 8 6 5 4 3 Incremental taxable profit 2 4 5 6 7 Incremental tax 1 1 2 2 2 Incremental profit after tax (PAT) 1 2 3 4 4 Net salvage value of fixed assets 30 • Solution We need to factor-in the annual savings in manufacturing cost as an inflow
  • 31. CB Inputs – Example 2 $mn. Year 0 1 2 3 4 5 Net investment in plant -40 Savings in manf. costs (A) 10 10 10 10 10 Depreciation on old plant (1) 2 2 1 1 1 Depreciation on new plant (2) 10 8 6 5 4 Incremental Depreciation on new plant (2 minus 1) (B) 8 6 5 4 3 Incremental taxable profit (A-B) 2 4 5 6 7 Incremental tax 1 1 2 2 2 Incremental profit after tax (PAT) 1 2 3 4 4 Net salvage value of fixed assets 30 • Solution Only additional or incremental profit should be considered.
  • 32. CB Inputs – Example 2 $mn. Year 0 1 2 3 4 5 Net investment in plant -40 Savings in manf. costs (A) 10 10 10 10 10 Depreciation on old plant (1) 2 2 1 1 1 Depreciation on new plant (2) 10 8 6 5 4 Incremental Depreciation on new plant (2 minus 1) (B) 8 6 5 4 3 Incremental taxable profit (A-B) 2 4 5 6 7 Incremental tax 1 1 2 2 2 Incremental profit after tax (PAT) 1 2 3 4 4 Net salvage value of fixed assets 30 • Solution This is the salvage value of the new plant after 5 years. Note that the old plant’s salvage value is expected to be zero and hence the new plant salvage value is taken as it is. If the old plant had an estimated value greater than zero than this amount needs to lessened from the new plant’s salvage value. Also the net recovery of working capital margin is also expected to be zero.
  • 33. CB Inputs – Example 2 • Solution – NPV & IRR $mn. Year 0 1 2 3 4 5 Initial flow (Net investment in plant) -40 Operating flow 9 9 8 8 8 (Incremental PAT + Incremental Depreciation ) Terminal flow 30 (Net incremental salvage value of fixed assets) Net cash flow (A) -40 9 9 8 8 38 (Initial flow + operating flow + terminal flow) PV factor @15% (B) 1.0000 0.8696 0.7561 0.6575 0.5718 0.4972 PV of cash Flows (A)x(B) -40 8 7 5 5 19 NPV (Sum of PV of cash Flows) 3 IRR (Use Excel IRR function) 17.74%
  • 34. CB – Risk Analysis The basics of the risks associated with long term investments & how to factor – in such risks
  • 35. 1. Business Risk – effect of high proportion of fixed cost - example Three Key Risks $ mn. Alpha Inc. Beta Inc. Normal Recession Normal Recession Sales 200 120 200 120 Variable Cost -100 -60 -160 -96 Fixed Cost -80 -80 -20 -20 Profit/Loss 20 -20 20 4 Change in Sales (%) -40 -40 Change in Profits (%) -200 -80
  • 36. $ mn. Alpha Inc. Beta Inc. Normal Recession Normal Recession Sales 200 120 200 120 Variable Cost -100 -60 -160 -96 Fixed Cost -80 -80 -20 -20 Profit/Loss 20 -20 20 4 Change in Sales (%) -40 -40 Change in Profits (%) -200 -80 1. Business Risk – effect of high proportion of fixed cost - example Three Key Risks Alpha has a higher proportion of fixed cost while Beta has a lower proportion.
  • 37. $ mn. Alpha Inc. Beta Inc. Normal Recession Normal Recession Sales 200 120 200 120 Variable Cost -100 -60 -160 -96 Fixed Cost -80 -80 -20 -20 Profit/Loss 20 -20 20 4 Change in Sales (%) -40 -40 Change in Profits (%) -200 -80 1. Business Risk – effect of high proportion of fixed cost - example Three Key Risks The negative effect of fixed cost is felt when economic downturns happen. By the same token the high proportion of fixed has a positive effect when the economy booms. Alpha is said to have a high operating leverage as compared to Beta.
  • 38. 2. Financial Risk v. Thus Financial Leverage = Long Term Debt/Shareholders funds. v. A 1:1 ratio indicated that debt and equity capital are equally employed. A ratio greater than 1 indicates higher level of debt in relation to equity and vice versa. vi. The higher the financial leverage, the greater the fixed obligations, the greater the risk of non-payment with changing economic conditions as operating cash flows get effected. Three Key Risks
  • 39. 3. Portfolio or Market Risk i. This arises from the variability of returns to the shareholders as a result of the business and financial risk. ii. This risk to shareholders is called firm specific risk. iii. Shareholders however can diversify this risk by holding a well diversified portfolio where the adverse performance of one investment can be offset by better performance by others. iv. In such a situation the variability of return to shareholders arise due the macro factors – such as interest rates, exchange rates etc. that make the markets go up or down Three Key Risks
  • 40. v. If the economy does well, the firm normally should do well and hence its projects. vi. Due to this the stand-alone risk can be considered to a close proxy for difficult-to- measure business and market risk. vii. To assess the stand alone risk of the project the starting point is to assess the uncertainty inherent in the projected cash flows. viii. Thus when a firm projects sales of 50000 units @ $ 500, the firm knows that the actual figure is very likely to be different and the figures are just expected values. Project Risks
  • 41. • Once we have a measure of the risk this can then be incorporated in the discount rate. • The discount rate can be seen to be made up of two components • The risk free rate plus • A risk premium for the risk in the project • This additional return for the risk taken increases as the perception of risk increases. • The higher the expected return or discount factor the lower the NPV. Factoring-in the Risks
  • 42. • Any new project requires a lot of administrative and coordination efforts. • The human resources management is also an additional factor given the internal equations/in- equations and politics that most organizations face. • To make sure that the project is truly worth over and above these and such ‘headache’ or ‘intangible’ factors, managements usually set minimum hurdle rates. • These rates are decided a matter of policy & arise from the past experiences, return expectations of shareholders, overall interest rate environment etc. Factoring-in the Risks
  • 43. • Firms do not look at capital investment decisions on a stand alone basis. • It is considered within the overall business context, its goals and strategic direction. • Every investment decision is therefore looked at in the context of existing investments i.e. a portfolio approach is taken. • Thus when proposals for capital investment come from various parts of a firm, apart from the returns that the project offers firms also evaluate • The market attractiveness of the proposal • The competitive strength of the firm Strategic Considerations
  • 44. • Firms do not look at capital investment decisions on a stand alone basis. • It is considered within the overall business context, its goals and strategic direction. • Every investment decision is therefore looked at in the context of existing investments i.e. a portfolio approach is taken. • Thus when proposals for capital investment come from various parts of a firm and apart from the returns that the project offers firms also evaluate • The market attractiveness of the proposal • The competitive strength of the firm Strategic Considerations It is indicated by a firm’s market share and its growth rate, brand loyalty, profitability, and technological and other comparative advantages.
  • 45. Mckinsey-GE Portfolio Matrix High Medium Low High Invest & Grow Invest & Grow Improve & Defend (selective Investment) Medium Invest & Grow Improve & Defend (selective Investment) Harvest or Divest Low Improve & Defend (selective Investment) Harvest or Divest Harvest or Divest Business Strength (BS) MarketAttractiveness(MA)
  • 46. MarketAttractiveness(MA) Mckinsey-GE Portfolio Matrix High Medium Low High Invest & Grow Invest & Grow Improve & Defend (selective Investment) Medium Invest & Grow Improve & Defend (selective Investment) Harvest or Divest Low Improve & Defend (selective Investment) Harvest or Divest Harvest or Divest Business Strength (BS) Where either MA or BS is relatively low, get maximum out of existing business i.e. try and maintain cash flows by incurring only replacement capex, tight control on WC and other costs.
  • 47. Capital Budgeting – Process The processes involved in long term investment decisions & its implementation
  • 48. • The CB process is broadly on the following lines • Idea generation – scanning the market/environment for opportunities or looking at internal issues/bottlenecks and finding solutions • Assembling the proposed investments – • Classification of investments into replacement, expansion, diversification, new product etc. • Defining the project clearly i.e. purpose, rationale, time frame, benefits etc. both in technical & economic terms. This normally requires information & data gathering – internally & externally. CB – Process Explained
  • 49. • Review alternatives • Evaluate the consequences of not implementing the project. • Based on the above the project may be accepted/approved or sent for review/additional details. • Implementation, monitoring & control • A map of set of linked activities, timelines for each, responsibilities & authority for the each task etc. is set out, communicated and agreed. • Initiation activities such as raising funds, placing equipment orders etc. are done as per above. CB – Process Explained
  • 50. • Time delays, cost escalations, contingencies not foreseen etc. are critically examined and required action/measures taken – in adverse situations even abandoning the project. • Post implementation audit – done after a year or so after implementation • Is the project delivering the intended objective/benefit? • Forecast Vs actual cash flows • Any thing that can be done to bring it to the intended track if need be? • Learning for future appraisals & implementations. CB – Process Explained
  • 51. Thank You
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