Managing Finance and Budgets

1
Managing Finance and Budgets

• Lecture 7
• Investment Appraisal

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Session 7 - Investment Appraisal

• LEARNING OUTCOMES
• Understand and choose relevant investment
  decision techniques to critically analyse
  situations typically found in SMEs and VCOs and
  to inform decision making.

3
Session 7 - Investment Appraisal

• KEY CONCEPTS
• Purpose of Investment Appraisal
• Accounting Rate of Return
• Payback
• Discounted Cash Flow
• Internal Rate of Return
• Cost-benefit analysis

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What is Investment?
5
Investment Decisions

• In this lecture we look at how businesses make
  investments in new plant, machinery and other
  long-term assets.
• Part of this will be to look at financial
  measures which can guide a manager in their
  decision-making
• A further element will be the ways in which
  Capital Investment Projects can be monitored and
  controlled.

6
Investment Decisions - Example

• A Hotel Group which has seen a downturn in its
  profitability has carried out market research
  that would suggest that turning one or more of
  its hotels into theme hotels offering a turn
  back the clock experience to particular age
  groups (e.g. the complete feel of being in the
  1960s or 1970s with décor, TV images,
  newspapers etc.) would have great appeal.
• To convert one hotel (60 guests capacity) would
  cost 150,000. Annual maintenance would cost a
  further 5,000 p.a.
• The Directors need to decide whether or not such
  an investment would be worthwhile. What factors
  should they take into consideration?

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Investment Decisions - Example

• The Directors would need to consider
• The current level of profitability of the hotel
• The expected increase in occupancy (or possibly
  decrease!) that would arise from the conversion
• The pricing structure for this experience
  possibly guests would be willing to pay more for
  this.
• Altogether we would need to look at the increase
  in profit that could be expected over , say, a
  five year period.
• If this proved to be greater than the 175,000
  (i.e. 150K 5K p.a.), then the direction would
  probably be to proceed.
• NB Given that there has been a downturn in
  profits, we might proceed even if the expected
  increase in profits does not exceed 175,000

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The Nature of Investment Decisions

• Investment means sacrificing wealth (or
  consumption) now for promise of future returns
• Time this is an important feature of all
  investment decision-making, as we are outlaying
  now (cash or resources) something which will
  potentially give us benefits in the future.
• Size of the Investment - Large Amounts of
  Resources are often involved if the wrong
  decision is made, the effect could be
  catastrophic.
• Irreversibility Once the decision has been made
  to invest (for example in new premises), it is
  very difficult, without significant loss to
  reverse the decision.

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Investment Appraisal (1)

• Therefore, investments need to be carefully
  appraised because of their
• potential impact on the organisation
• strategic importance
• comparative size of the expenditure
• difficulty of reversing them
• potential risk to the existence of the
  organisation.

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Investment Appraisal (2)

• Elements which need to be appraised include
• The amount of the investment
• The timing and the amount of the returns
• The level of risk
• Generally, the higher the risk, the higher the
  expected rate of return
• Some organisations will have different required
  rates of return for low, medium, or high risk
  projects

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Types of Investment

• Replacement of existing facilities - relatively
  low risk
• Expansion of existing facilities - relatively low
  risk
• New project - higher risk because of unknowns
• Research development - highly risk and
  uncertain
• Welfare projects - benefits difficult to measure

12
Investment Appraisal Tools
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Investment Appraisal

• Organisations use some or all of a range of tools
  to identify the nature of projects and their
  likely return
• Accounting rate of return (ARR)
• Payback Period (PP)
• Net present value (NPV)
• Internal rate of return (IRR)

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Accounting Rate of Return

• The Accounting Rate of Return measures the
  average accounting profit generated over the life
  of the project
• The Accounting Rate of Return is expressed as a
  percentage of the average investment.
• The Accounting Rate of Returns for different
  projects may be compared to see which provides
  the higher return on the average investment

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Accounting Rate of Return (ARR)

• The formula for ARR is
• Average Annual Profit x 100
• Average Investment to earn the Profit.
• The Average Annual Profit will normally be
• (Total Profit Total Depreciation) / Number of
  years
• The Average Investment will normally be
• (Initial Cost Disposal Value) / 2.

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Accounting Rate of Return (ARR)

• For example
• A machine which was originally bought for
  100, 000 is sold five years later for 20, 000.
  Over the five years in the machine made profits
  before depreciation of 20,000, 40,000,
  60,000, 60,000 and 20,000.
• Average Annual Profit (Total profit Total
  Depreciation)/ Years
• (2000040000600006000020000)
  (100000-20000) / 5
• 24,000
• Average Investment (Initial Investment
  Disposal Value) / 2
• (100000 20000) / 2
• 60000
• ARR 24000 x 100 40
• 60000

This means that the machine has produced 40 of
its value (on average) during each of its five
years
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Accounting Rate of Return Further Example

• PROJECT ONE PROJECT TWO
• Investment 300,000 500,000
• Cashflow Depn Net Profit
  Cashflow Depn Net Profit
• Year 1 90,000 60,000
  30,000 120,000 100,000 20,000
• Year 2 160,000 60,000 100,000
  140,000 100,000 40,000
• Year 3 120,000 60,000
  60,000 160,000 100,000 60,000
• Year 4 70,000 60,000
  10,000 240,000 100,000 140,000
• Year 5 70,000 60,000
  10,000 320,000 100,000 220,000
• Totals 510,000 300,000 210,000
  980,000 500,000 480,000
• ARR Average profit/Average
  investment
• (210,000/5)/ (300,000/2)
  28 (480,000/5)/(500,000)/2 38.4

In this case, the depreciation has been included
as part of the Net Profit calculation
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Accounting Rate of Return

• It is simple to understand
• What percentage profit has been generated on the
  item?
• Parallels Return on Capital Employed
  calculation
• Produces a return
• BUT
• Ignores time factor
• Focuses on Accounting Profit - ignores cash-flow
• Does not distinguish between projects of
  different size

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Payback Period (PP)

• The Payback Period calculates how long before the
  investment is repaid
• This is calculated by
• Comparing initial investment to cash-flow
• Finding the year in which the total of cash
  received so far exceeds investment.
• The proportion of year needed can be calculated
  as follows
• Balance outstanding at start of year
• Cash received during the year

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Payback Period an Example

• A machine which was originally bought for
  100, 000 is sold five years later for 20, 000.
  Over the five years in the machine made profits
  before depreciation of 20,000, 40,000,
  60,000, 60,000 and 20,000.
• The total for the first three years 120,000.
  This exceeds the original investment, so that the
  Payback period is between 2 and 3 years.
• In fact for the third year
• Balance outstanding at start of year 40000
  2/3 (i.e 8 months)
• Cash received during the year
  60000
• So the Payback Period is 2 years and 8 months.

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Payback Period Further Examples

• PROJECT ONE PROJECT TWO
• Investment 300,000 500,000
• Cashflow Depn Profit
  Cashflow Depn Profit
• Year 1 90,000 60,000
  30,000 120,000 100,000 20,000
• Year 2 160,000 60,000 100,000
  140,000 100,000 40,000
• Year 3 120,000 60,000
  60,000 160,000 100,000 60,000
• Year 4 70,000 60,000
  10,000 240,000 100,000 140,000
• Year 5 70,000 60,000
  10,000 320,000 100,000 220,000
• Totals 510,000 300,000 210,000
  980,000 500,000 480,000
• PAYBACK 2 years 50,000/120,000
  3 years 80,000/240,000
• 2 years and 5 months
  3 years and 4 months

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Payback Period

• Simple to understand
• Focuses on Cash-flow
• BUT
• Ignores time factor
• Ignores what happens AFTER project has been paid
  back for example if a 500K machine produced
  increasing profits over its 5-year life of 100K,
  200K, 300K, 400K and 500K, PP 2 years 8
  months, but the full cost of the machine is
  covered by the profits in the final year.
• Does not distinguish between projects of
  different size

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Activity One

• A company is considering investing in either of
  two new machines which will help to increase its
  production. The first machine will cost 240,000,
  and the company estimates that it will have a
  working life of 5 years. The second machine will
  cost 360,000 and have a working life of 6 years.
  The net positive cash-flows as a result of cost
  savings from the new machine are shown below.
  Calculate the payback period and Accounting Rate
  of returns for each of the machines.
• Machine 1 Net Cash-flows 90,000/yr
  for first 3 years
• 50,000/yr for remaining 2 years
• Machine 2 Net Cash-flows 100,000 Year 1
• 110,000 Years 2
• 120,000 Years 3 and 4
• 90,000 Years 5 and 6

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Activity One Solution Part 1

• Machine 1
• Cost 240K Life 5 years
• Net Cash-flows 90K /yr for first 3 years
• 50K /yr for remaining 2 years
• ARR
• Average Profit (3 x 90000) (2 x 50000) -
  240000 ? 5 26000
• Average Investment (240000 0) ? 5 48000
• ARR 26000/48000 54.2
• PP
• In the first two years, Total Cash flow
  180000,
• so the PP will occur sometime in year three
• Proportion of year three (240000-180000)/90000
  8 months
• PP 2 years and 8 months

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Activity One Solution Part 2

• Machine 2
• Cost 360K Life 6 years
• Net Cash-flows 100K, 110K, 120K, 120K,
  90K, 90K
• ARR
• Average Profit (100000110000 120000x2
  90000x2) - 360000 ? 6 45000
• Average Investment (360000 0) ? 6 60000
• ARR 45000/60000 75
• PP
• In the first three years, Total Cash flow
  330000,
• so the PP will occur sometime in year four
• Proportion of year four (360000-330000)/120000
  3 months
• PP 3 years and 3 months

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Activity One -Summary

• Machine 1 ARR 54.2 PP 2 years 8 months
• Machine 2 ARR 75 PP 3 years 3 months
• Analysis
• If we opt for the Machine 1, it will cost less,
  and we will recoup our initial expenditure 7
  months sooner. However the second machine
  promises greater return on our investment in the
  long run.
• Decision
• If the company can secure the finances (e.g.
  long term loan over 4 years ), then Machine 2
  represents a much better investment. If finances
  are a problem, then we may have to settle for
  Machine 1.

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The Value of Money (1)

• The methods used so far have only taken into
  consideration the profits made and the cost
  incurred through depreciation
• We have assumed that the future value of the
  money is equal to its present value.
• However, this may not be true If we invest 100K
  in a machine,
• we risk our money,
• we are losing interest on it (we could have put
  it in a Building Society),
• through inflation 100K in a years time will buy
  less than it can today.

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The Value of Money (2)

• Making some broad assumptions, we can put a
  figure to the losses that are incurred through
  the three elements of risk, loss of interest and
  inflation for example 10 per year This is
  called the Discount Rate.
• This allows us to calculate what the value of 1
  would be in
• 1 years time 90.1p
• 2 years time 82.6p
• 3 years time 75.1p
• 4 years time 68.3p

The formula for the calculation is Amount of
Cash in Year N (1 rate)N
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The Value of Money (2)

• Making some broad assumptions, we can put a
  figure to the losses that are incurred through
  the three elements of risk, loss of interest and
  inflation for example 10 per year This is
  called the Discount Rate.
• This allows us to calculate what the value of 1
  would be in
• 1 years time 90.1p
• 2 years time 82.6p
• 3 years time 75.1p
• 4 years time 68.3p

Sample Calculation Details 1.00
1.00 0.683 (1 0.10)4 1.461
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Net Present Value (1)

• This Method allows us to calculate the current
  value of the projects returns at a given
  discount rate to allow for the time value of
  money, i.e. the fact that money received in
  several years time will actually be worth less
  than it is now.
• These discount factors may be found in tables, or
  from spreadsheets, or by using the formula as in
  the the previous slide.

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Net Present Value (2)

• The calculation involves
• The initial cost of the Project (negative cash
  flow)
• The values of the incoming Cash flows (positive)
  for the project in each in each subsequent year
  at the discounted rate.
• Example
• Machine costs 900 -900.00
• Year 1 Cash-flow 500 (_at_ .901) 450.50
• Year 2 Cash-flow 500 (_at_ .826) 413.00
• Year 3 Cash-flow 500 (_at_ .751) 375.50

These discount rates (10 per annum) are taken
from the previous calculation
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Net Present Value (3)

• Example
• Machine costs 900 -900.00
• Year 1 Cash-flow 500 (_at_ .901) 450.50
• Year 2 Cash-flow 500 (_at_ .826) 413.00
• Year 3 Cash-flow 500 (_at_ .751) 375.50

With the discounting, we can see that the actual
value that we recoup in two years (discounted to
present value) is only 863.50. This is less than
the 900 paid out.
Without the discounting, we would claim that we
recoup the cost (and more) in two years, as the
machine costs 900 and our returns are 1000
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Net Present Value (4)

• The figures are totalled for
• The initial cost (negative)
• The discounted values of the subsequent Cash-
  flows (positive)
• This gives the Net Present Value
• If the Net Present Value (NPV) is positive at a
  particular discount rate (e.g.) then it means the
  project will return more than that rate
• If the NPV is negative then it will return less
  than that rate
• An organisation may choose a rate equivalent to
  its required return or equivalent to its Weighted
  Average Cost of Capital (WACC)

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Net Present Value - Examples

• PROJECT ONE PROJECT TWO
• Discount
  Discount
• Cashflow Factor DCF
  Cashflow Factor DCF
• Invmnt -300,000 1 -300,000
  500,000- 1 500,000-
• Year 1 90,000 0.909 81,810
  120,000 0.909 109,080
• Year 2 160,000 0.826 132,160
  140,000 0.826 115,640
• Year 3 120,000 0.751 90,120
  160,000 0.751 120,160
• Year 4 70,000 0.683 47,810
  240,000 0.683 163,920
• Year 5 70,000 0.621 43,470
  320,000 0.621 198,720
• Totals
  95,570
  207,520
• The above figures use a Discount Rate of 10

DCF Discounted Cash Flow
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Net Present Value

• Allows for time value of money
• Produces a figure which also allows you
  distinguish between projects of different size
• Considers the full life of the project
• BUT
• More complicated to use and understand

36
Activity Two

• For the scenario described in Activity One,
  calculate a Net Present Value for each of the two
  machines, using a Discount Rate of 10 and a
  Discount Rate of 20. The Discount Factors at the
  two rates are shown below
• 10 20
• Year 1 0.909 0.833
• Year 2 0.826 0.694
• Year 3 0.751 0.579
• Year 4 0.683 0.482
• Year 5 0.621 0.402
• Year 6 0.565 0.335

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Activity Two Solution (1)

• MACHINE ONE MACHINE TWO
• Discount
  Discount
• Cashflow Factor DCF
  Cashflow Factor DCF
• Invmnt -240,000 1 -240,000
  360,000- 1 360,000-
• Year 1 90,000 0.909 81,810
  100,000 0.909 90,900
• Year 2 90,000 0.826 74,340
  110,000 0.826 90,860
• Year 3 90,000 0.751 67,590
  120,000 0.751 90,120
• Year 4 50,000 0.683 34,150
  120,000 0.683 81,960
• Year 5 50,000 0.621 31,050
  90,000 0.621 55,890
• Year 6
  90,000 0.565
  50,850
• Totals
  48,940
  100,580
• The above figures use a Discount Rate of 10

NOTE This calculation is highly sensitive to
rounding errors. Note how the calculations on the
spreadsheet using 4dp give slightly different
answers of 49,013 and 100,623
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Activity Two Solution (2)

• MACHINE ONE MACHINE TWO
• Discount
  Discount
• Cashflow Factor DCF
  Cashflow Factor DCF
• Invmnt -240,000 1 -240,000
  360,000- 1 360,000-
• Year 1 90,000 0.833 74,970
  100,000 0.833 83,300
• Year 2 90,000 0.694 62,460
  110,000 0.694 76,340
• Year 3 90,000 0.579 52,110
  120,000 0.579 69,480
• Year 4 50,000 0.482 24,100
  120,000 0.482 57,840
• Year 5 50,000 0.402 20,100
  90,000 0.402 36,180
• Year 6
  90,000 0.335
  30,150
• Totals
  -6,260
  -6,710
• The above figures use a Discount Rate of 20

NOTE Spreadsheet answers this time (using 4dp)
give -6,210 and -6,653
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Activity Two Solution Summary

• DF 10 DF 20
• NPV of Machine 1 48,940 -6,260
• NPV of Machine 2 100,580 -6,710
• Analysis
• If the value of money is decreasing at 10 per
  annum (low risk, low inflation, low interest),
  then Machine 2 is a much better proposition,
  earning over 50K more.
• However, if the value of money is decreasing at
  20 per annum (high risk, high inflation, high
  interest) then Machine 1 is a slightly better
  proposition, as its loss is somewhat less.
  However, the value of purchasing any machine
  under these circumstances is questionable.

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Internal Rate of Return (IRR)

• In the previous example, we can see that at a
  discounting rate of somewhere between 10 and 20
  the NPV0
• At this rate, the project would simply break
  even, that is, the returns would exactly match
  the investment.
• This discount rate which would give a Net Present
  Value of Zero is called the Internal Rate of
  Return
• The IRR (Internal Rate of Return) is the
  projects net rate of return allowing for time
  factors.

41
Internal Rate of Return (IRR)

• This can be calculated using spreadsheet
  functions, or by calculation using one discount
  rate which produces a negative NPV (Higher
  Discount Rate) , and one discount rate which
  produces a positive NPV (Lower Discount Rate)
• Calculation Formula
• IRR Lower Discount Rate
• NPV of Lower Discount Rate_____ x
  Difference in
• NPV of lower rate - NPV of higher rate
  discount rates

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Internal Rate of Return Example

• IRR Lower Discount Rate
• NPV of lower discount rate
  x Difference in
• NPV of lower rate - NPV of higher rate
  discount rates
• For Machine 1 Lower Discount (10) Higher
  Discount (20)
• Net Present Value 48,940
  -6,260
• IRR of Machine 1 10 ( 48940 )
  x (20-10)
• 48940- (-6260)
• 10 (0.8865 x 10) 18.87
• 
  

43
Internal Rate of Return Example

• IRR Lower Discount Rate
• NPV of lower discount rate
  x Difference in
• NPV of lower rate - NPV of higher rate
  discount rates
• For Machine 2 Lower Discount (10) Higher
  Discount (20)
• Net Present Value 100,623
  -6,653
• IRR of Machine 2 10 ( 100623
  ) x (20-10)
• 100623- (-6653)
• 10 (0.9374 x 10) 19.37
• 
  

44
Internal Rate of Return

• Allows for time value of money
• Produces a percentage return which can be
  compared to an organisational benchmark
• Considers the full life of the project
• BUT
• Does not distinguish between projects of
  different size
• Seen as complicated to use and understand

45
Cost-Benefit Analysis
46
Criticisms of Conventional Analysis Tools

• The tools concentrate purely on cash or profit,
  and ignore the often more important strategic
  gains that can be made in a particular
  investment.
• More particularly, they do not attempt to assess
  the disadvantages which can occur through NOT
  making the investment.
• Each tool focuses on one aspect of the
  investment, e.g the time needed to recoup the
  losses, or the total profit in real terms.
  These sometimes give conflicting results, and can
  confuse rather than enlighten.
• The more sophisticated the tool, the less easy it
  is to interpret.

47
Cost Benefit Analysis

• For large, complex projects whose effects can be
  far-reaching, it is often better to use a
  Cost-Benefit Analysis
• This is broader than simply a cash or profit
  based analysis
• It seeks to assess economic and social advantages
  (benefits) and disadvantages (costs) of project
  by quantifying them in monetary terms
• It can be relevant where economic or market
  factors provide insufficient information for
  decision-making

48
Cost Benefit Analysis some difficulties

• It is sometimes very difficult to estimate the
  value of social costs,
• For example Siting a factory near to a housing
  estate.
• It is difficult to allow for changes in levels of
  costs and benefits over time, either through
  inflation or through social changes..
• For example in times of low employment, siting a
  factory near to a housing estate might be seen
  as a benefit in times of high employment it
  would be seen as a cost.
• It is an imprecise procedure different
  assumptions produce different results. There is a
  need to specify assumptions clearly.
• In an ideal form, the analysis should show range
  of results under different assumptions and
  different criteria.

49
Cost Benefit Analysis - Example

• Victoria Line extension
• Costs Capital expenditure. Running Costs.
  Disruption during construction. Additional
  traffic near new stations.
• Benefits Time saved on underground journeys, BR
  journeys and bus journeys. Comfort/convenience.
  Time saved on car journeys. Reduced car running
  costs. Fare savings. Costs saved on road repairs.
  Reduced road accidents. Reduced pollution.
  Reduced traffic and noise.
• Each of these can (with some ingenuity) be costed
  in monetary terms. A balance sheet is then
  drawn up to weigh the total benefits against the
  total costs, and showing the contribution of each
  item.

50
Follow-up Activities

• Read Chapter 14 (including EPNV)
• Describe key concepts
• Purpose of Investment Appraisal
• Accounting Rate of Return
• Payback Period
• Discounted Cash Flow
• Internal Rate of Return
• Cost-benefit analysis
• Exercises 14.1 and 14.2

51
Internal Rate of return Example 1

• IRR Lower Discount Rate
• NPV of lower discount rate
  x Difference in
• NPV of lower rate - NPV of higher rate
  discount rates
• MACHINE ONE 10 ( 48940 ) x
  (20-10) 10 (0.8865 x 10) 18.87
• 48940-
  -6260
• MACHINE TWO 10 ( 100580 ) x (20-10)
  10 (0.9374 x 10) 19.37
• 100580-
  -6710