Capital Investment

1
Capital Investment

• Penri James
• 2005

2
Definition of Capital

• wealth in the form of money or property owned by
  a person
• business and human resources with an economic
  value
• assets available for use in the production of
  further assets

3
Sources of Capital

• Own Capital
• Assets (net worth)
• Retained Profits
• Capital Grants
• Government and Agencies
• Creditor Capital
• Banks, private investors

4
Interest

• The reward to capital
• Interest is the payment to the lender for
  postponing the consumption of capital PURE
  INTEREST
• Service charges - ADMINISTRATION
• Profits REWARD FOR RISK
• Expressed as a rate

Administration
Pure Interest
5
Interest Rates

• Interest Rates apply the charge on borrowing
  money
• Agreed percentage rate over a period of time

6
Variable Interest Rates

• Vary throughout duration of loan
• Vary according to cost of borrowing by lender
• Unpredictable and uncertain cost

7
Fixed Interest Rates

• Constant rate
• Certain predictable cost

8
Break Loans

• Changes between variable and fixed rate
  throughout duration of loan

time
9
Interest rates

• Base Rate
• Annual Nominal Rate
• Applied to daily balance outstanding
• Base rate x
• Period rate
• Annual Nominal rate for periods of less than a
  year
• Flat rate
• of original amount borrowed

10
Interest Rates (from LloydsTSB)

• GROSS RATE
• The contractual rate of interest payable before
  deduction of income tax at the rate specified by
  law
• NET RATE
• The rate of interest which would be payable after
  allowing for the deduction of income tax at the
  rate specified by law.
• AER
• AER stands for Annual Equivalent Rate and
  illustrates what the interest rate would be if
  interest was paid and compounded once each year. 
  As every advert for a savings product will
  contain an AER you can compare more easily what
  return you can expect from your savings over
  time.
• TAX FREE RATE
• The annual interest rate when interest is exempt
  from income tax.Interest is normally paid at the
  net rate unless the Account falls within an
  exempt category or the Account holder qualifies
  to receive interest gross. Interest rates may
  vary from time to time. All rates are per annum
  except where stated.

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Factors that affect Interest Rates

• Cost of money to financial institutions
• Government policy (Bank of England Monetary
  Policy Committee)
• Oil prices
• International interest rates
• Supply and demand for money
• Inflation
• Method by which financial institutions raise
  money
• Deposit vs Current accounts (Loanable Funds
  Theory of Interest)
• Fixed or variable rates
• Risk factor

12
Loanable Funds Theory of Interest

• When DEMAND (Current) increases or SUPPLY
  (Deposit) decreases then interest rates rise
• When DEMAND (Current) decreases or SUPPLY
  (Deposit) increases then interest rates fall

13
Loanable Funds Theory of Interest
14
Loanable Funds Theory of Interest
15
Annual Percentage Rate

• Consumer Credit Act 1974
• APR sets all quoted interest rates on an equal
  basis

where n nominal interest rate in decimal p
number of instalments per year
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APR example
Nominal rate 15 Number of instalments 4
(quarterly)
17
Annual Percentage Rate
18
Interest Rate

• An Interest Rate is the exchange rate between
  todays currency and money in tomorrows currency

19
The concept of compounding

• Compounding gives the future value of money
  invested today
• It is a function of
• Time
• Interest (Discount) Rate
• Amount invested

20
The concept of compounding
where n number of years i interest rate in
decimal
21
Compounding - example

• What is the future value of
• 100 invested at 12 for 3 years
• Solution

22
Compounding tables
23
The concept of discounting

• Discounting gives the present value of a sum
  received at a time in the future

where n number of years i interest rate in
decimal
24
Discounting - example
or
25
Discounting tables
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Loan characteristics

• Fixed amount
• Principal of the loan
• Specific period
• Interest rate
• Charge period

27
A loan or a mortgage?

• Loan
• Borrow money usually without security
• Mortgage
• Mortgagor obtains a loan from a Mortgagee on the
  security of a property
• Deeds relating to the land are transferred whilst
  loan is repaid
• Mortgagee has the right to reposess on repayment
  default

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Reducing Balance Loan

• Easy to Calculate
• Equal Capital Repayments
• Interest Charged on outstanding balance at END of
  Charge Period

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Annuity Loan

• where i interest in decimal
• n term of loan in years

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Annuity Loan

• Equal Repayments
• Increasing Capital Portion
• Decreasing Interest Portion

31
Endowment Loan

• Interest Charged on Total Through Term of Loan
• Premium Charge is dependent on status
• Loan Repayment on Maturity
• With Profits or Deficit
• Not offered as an option by lenders after
  mis-selling scandal

32
Problems with endowment loans
33
What is Investment Appraisal?

• Selecting investments where the benefits of the
  investment outweigh the costs
• Cash generated by the project more than outweighs
  the lost opportunity to invest in other projects.

34
Types of Investment

• Expansion of existing facilities
• Diversification into new products or new markets
• Cost reduction investments
• Automation, mechanisation
• Safety and maintenance investments

35
Investment selection
Identify Objectives
Search for Investment Opportunities
Initial Screen
List Possible Outcomes
Measure Cashflow
THE BIN
Select Investment Projects
Review investment decision
36
Capital Budgets

• How much money is available for investment?
• Select capital project which gives greatest
  return on the investment
• INVESTMENT APPRAISAL
• Quality of investment
• showing a net benefit
• Capital constraints
• financing method

37
Allocating Capital

• Growth Investment
• Land purchase
• Dairy herd increase
• New pig unit

• Safety investment
• New tractor
• Waste control
• Dust extractor

• Rank according to feasability
• Rank according to priority
• statutory
• strategy
• Rank according to benefits

38
Investment Appraisal Techniques

• Payback method
• Discounted Payback method
• Net Present Value
• Internal Rate of Return
• Profitability Index

39
Payback method

• Investment is recouped within a period of time
• Period length based on
• past experience
• forecasting accuracy
• Method - successive cash inflows are added
  together until cumulative cash inflow is greater
  than the cash outlay

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Payback method example

• Self propelled forage harvester purchased for
  80,000
• Calculate the payback period

41
Payback method solution
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Payback method

• Advantages
• Simple and quick
• Disadvantages
• Takes no account of time element
• Ignores cash flows ouside payback period
• Cut off point is arbitrary - makes decision
  subjective
• Short term only

43
Discounted Payback method

• Removes time criticism from Payback - others
  remain

44
Discounted Payback method example

• Self propelled forage harvester for 80,000 at a
  discount rate of 13
• Calculate the payback period

45
Discounted Payback method solution
46
Problems with Payback (non discounted and
discounted)
UNCERTAIN END RESULT WITH INCONSISTENT CASHFLOW
constant cashflow
47
Net Present Value (NPV)

• NPV compares todays cash oulay with future cash
  inflows from the investment
• Convert future cash into todays currency using
  discount factors

48
Net Present Value (NPV) - components

• Initial Cash Flow / Investment Cost
• Net Cash Inflows
• additional revenue
• Lifespan of the Investment
• Cost of Capital
• market rate of interest for an investment
• linked to RISK

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Net Present Value (NPV)
COST OF CAPITAL
LIFESPAN
NPV
CASH INFLOW
INITIAL INVESTMENT
Estimated operating costs
Estimated Price
Estimated sales volume
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Net Present Valuemethodology

• Initial Cash Flow (capital investmet) is
  estimated
• Periodic net cashflows which result from
  investment are calculated
• Terminal value (if any) is calculated and added
  to last years cash flow
• Opportunity cost of capital is calculated and
  used as discount rate
• Net Present Value calculated

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NPV with regular cash flows

• Present Values are additive with both regular and
  irregular cash flows
• With regular cash flows discount factors are also
  additive - cumulative discount factor

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NPV with regular cash flows - example
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NPV on Excel

• NPV can be calculated using the function
• NPV(rate, value1, value2, ...)
• Modelling
• Cash flow
• Receipts
• Payments
• Opportunity cost

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Internal Rate of Return (IRR)

• Discounted cash flow approach similar to NPV
• Calculates the rate of return required to make
  the NPV of the investment zero
• At what rate of return will the NPV of the
  investment be zero?

55
IRR

• Projects are accepted if the IRR is less than the
  opportunity cost of borrowing capital
• The IRR is the maximum cost of capital without
  incuring a loss on the investment

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IRR
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IRR

• 3 methods of calculation
• Interpolation
• Calculator
• Computer model

58
IRR - interpolation

• Calculate NPV using high discount rate
• to give negative NPV
• Calculate NPV using low discount rate
• to give positive NPV
• Plot on graph
• High and low rates should be close to IRR

59
IRR - interpolation

• As discount rate increases then NPV decreases
• On a graphic representation of NPV and discount
  rate - at a point where NPV0 then an
  approximation of IRR can be made on the discount
  rate axis

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IRR

NPVgt 0
npv
rate
NPVlt 0
-
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IRR interpolation exercise

• Plot chart - Rate (x axis) vs NPV (y axis)
• Estimate IRR

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Interpolation exercise summary
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IRR - interpolation problems

• IRR involves compound interest calculations
• Progression between two points is a curve and not
  linear
• The further apart the high and low rates then the
  less accurate the interpolation

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IRR - interpolation problems
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IRR - interpolation problems
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IRR calculator (10 15)
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IRR calculator (12 14)
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IRR - Excel

• IRR(values, guess)
• Values is the values for a cash flow series
  for which you want to calculate the internal rate
  of return.
• Guess is a number that you guess is close to
  the result of IRR.

69
IRR - a critique

• No need to specify the opportunity cost of
  capital
• Returns a and not a value
• Not suitable for making comparisons over
  different time horizons

70
Profitability Index

• Rearrangement of NPV

If Profitability Index is greater than 1 then the
project is worthwhile.
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The effect of tax on investment appraisal

• A successful investment will increase taxable
  profit
• Capital allowances are available for capital
  investment
• Businesses not making a profit have no tax
  liability

72
The effect of tax - capital allowances

• A capital allowance will reduce the tax burden
• Cash benefits arise from a capital allowance
• Capital allowances are available in the year
  following the purchase of an asset

73
Investment appraisal - tax

• GROSS ANNUAL CASH FLOW
• less
• CAPITAL ALLOWANCES
• less
• INTEREST ON INVESTMENT LOAN(if not already
  included in overheads)
• equals
• TAXABLE INCOME

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Investment appraisal - tax

• TAXABLE INCOME
• multiplied by
• MARGINAL TAX RATE
• equals
• TAX BURDEN
• Tax is payable in the year after the profit is
  assessed

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Inflation

• An increase in prices in an economy and
  consequent fall in the purchasing value of money
• Devaluing the worth of money
• (Discounting is the time value of money)
• Headline rate measured using Retail Price Index
  (RPI)

76
Inflation

• Caused by
• Excess demand in the economy - demand-pull
  inflation
• High production costs - cost-push inflation
• Excessive increase in money supply - monetarism

77
The effect of inflation
10,000 sum with 5 inflation
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Inflation and Investment

• Real returns exclude the effect of inflation
• Money returns include the effect of inflation
  (NOMINAL RETURN)
• Work consistently either in real or money terms -
  never mix both states

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How to adjust for inflation
Inflation rate and discount rate both expressed
as decimal
Inflation has a compounding effect
80
The compounding effect of inflation
where n number of years i inflation rate in
decimal
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Appraising an option

• Gather Information
• Set up CASH FLOWS
• Receipts
• Payments
• Calculate CAPITAL ALLOWANCES
• Calculate TAX BURDEN
• Calculate NET CASH FLOW
• Allow for INFLATION
• Calculate NPV , IRR

82
When to use alternative appraisal methods

• Do not rely entirely on one appraisal technique -
  use as many as possible

83
Setting criteria for any investment appraisal
technique

• It needs to take account of the time value of
  money
• Discount rate needs to accommodate the risk
  factor of the project
• It needs to cover the working life of the
  investment
• Objective measurement based on past not best
  performance