Chapter 2: Basic investment appraisal methods

Aims of the chapter

Like the topics in the first chapter of this guide, the topics in this chapter are integral to the subject as a whole since these basic techniques of time value of money and discounting are used in numerous other aspects of financial management. So carefully learn these concepts, and the process as well as the principles and the pros and cons concerning them. This chapter defines and explains the time value of money concept and applies it to problems of investment appraisal in a certain world. The relaxation of the assumption of certainty occurs in the following two chapters. Here we concentrate on the basics since the technique can be and is used in long-term and short-term investment appraisal, in evaluation of financing methods, valuing monetary assets, risk management etc. We start by describing the time value of money and then explain the concept and approach to the computational methodology used in a practical example of investment appraisal and selection. The net present value (NPV) is described very fully both in principle and application and in how the decision rules are derived. Different sets of circumstances are introduced to show how the NPV approach can cope with the situations met in an imperfect world, (e.g. taxation, inflation, different interest rates, repeat investments, mutually exclusive investments, capital rationing). Alternative methods of appraisal are also described, such as internal rate of return and pay-back. The major problem of an imperfect world and uncertain outcomes is dealt with later in Chapters three and four.

Learning objectives
By the end of this chapter and having completed the essential reading and activities, you should he able to: describe and apply the time value of money in project evaluation, whether it be future or present value oriented defend the use of NPV as the method of appraisal against other suggested methods prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances.

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Essential reading
Brealey, R.A., S.C. Myers and A.J. Marcus Fundamentals of Corporate Finance. (McGraw-Hill Inc, 2007) Chapters 4, 7, 8 and 9

Further reading
Brealey, R.A., S.C. Myers and F. Allen Principles of Corporate Finance. (McGraw-Hill, 2008) Chapters 2, 3, 6 and 7. Atrill, P. Financial Management for Decision makers. (FT Prentice Hall Europe, 2005) Chapters 4 and 5.

Time value of money

Money (i.e. cash) has a different value over time; holders of money can either spend the money on consumption now or delay the consumption by investing the money until it is required for consumption. The reward for the delay in spending is the interest received by investing. The amount of interest is dependent upon the amount of time and the rate of interest. The further into the future a consumer has to wait, the greater the interest compensation required. So if one knows of a certain future receipt of cash then there must be a certain value today, which we call the present value, which will be its equivalent. By receiving today an amount of cash equal to the present value, the recipient would be indifferent between the future receipt and todays receipt. The difference between the two receipts is the time value, the compensation for the passage of time. The present value of a future amount is also known as the discounted value.

Future value and compounding

Whenever someone makes an investment, he or she expects to earn a return which can take the form of interest when the investment is in some form of monetary asset. If the interest earned is reinvested rather than withdrawn then the total amount invested grows at a compound rate. At the end of the life of the investment (at maturity) it will have a value F the future or maturity value. If P is the amount invested today at r% with compound interest for t years then the future value will be F. F = P(1 + r)t

Present value and discounting

The converse of compounding is discounting. This uses as its basis the sane algebraic relationship but in the opposite way. The aim of discounting is to determine the present value of a future amount (i.e. todays amount) which, if invested at the rate of interest r, would achieve the future value predicted. With prospective new investments we can predict the incremental cash

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flows which will occur because of the investment, but as these predictions are all in money terms of differing values they must all be converted into a value at a common date (i.e. today, the day of the investment). Therefore we need to convert all cash flows into present values, todays values. So if we predict receiving F in t years time during which r is rate of interest then P is the present value of F, derived thus:

P=

F 1 =F t (1 + r ) (1 + r ) t

Note

1 is the discount factor. (1 + r) t

Using a computer, a table of discount factors for all combinations of r and t has already been prepared. This can be found at the back of all reputable texts. You should familiarise yourself with the compounding and discounting formulae and procedures and where they are used. Apply this knowledge to annuity payments or receipts. Remember an annuity is a constant annual amount and so the annuity factor for any year is the sum of the annual discount factors up to and including that year.

Interest rates, discount rates and real rates

An interest rate is the proportionate return on an investment appropriate for the risk level of the investment. So it could be the return on a bond, a companys investment or the required return a company has to pay on its loan etc. The expression discount rate is often used synonymously with interest rates because the discount factor is derived using an interest rate. Similarly, because companies use a mixture of capital types to fund their investments, that mixture has an average cost which the company has to service. Any investments made from that mix of capital must generate flows and in the evaluation of those flows we use the discounting process. We can use the expressions cost of capital, opportunity cost of funds, as alternatives to discount rate since the discounting factor is derived using the cost of capital. You must learn the difference between real and nominal interest rates. (The terms, money and actual interest rates, are also used to mean nominal rate). The nominal rate is the rate to be found in the market place. The real rate is the rate of interest that would persist if there were no inflation or deflation. (1 + real rate)(1+ inflation rate) = (1 + nominal rate) (1+ r)(1+ i) = (1+ n) N.B. Note the short cut sometimes used to derive the nominal rate (r+i) = n. Do remember this is only an approximation and will usually lead to over-valuing the present value of the future flows. Remember that different items of operating expenditure and revenues may have their own specific inflation rates and, when
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undertaking an investment appraisal, all cash flows prior to discounting should be quoted in actual or money flows for the specific period. All individual and specific inflation rates will have been separately accounted for (e.g. the degree of inflation may have been different from year to year or between say wages and materials). The discount factor used should only incorporate the inflation rate relevant to the capital providers who have to be serviced and repaid from the investment.

Activity 2.1 What is the time value of money? How is it different from the real and actual rates of interest of a risky investment? See VLE for solution

Basic investment appraisal techniques

Using BMM learn how to compute the net present value (NPV) for an investment, as well as an investments internal rate of return (IRR). Likewise learn how to compute the payback period (PP) and the accounting rate of return (ARR). The decision rules for each appraisal method should be learnt for the range of different types of decisions a manager might face, simple go/no go, selection between mutually exclusive projects and so on. See BMM sections 7.1 and 7.2.

Activity 2.2 Solve self-tests in BMM, numbers 4.1, 4.3, 4.4, 4.5, 4.8 and 4.14.

You must remember: that long term projects under consideration should be consistent with the long term corporate plan that the estimated cash inflows from the project when discounted to a common date, the present, exceed the estimated outflows, also discounted to the present that the theory in this section assumes certainty of knowledge and forecasting this is relaxed in the next chapter that, in practice, businesses do not wholeheartedly follow the theoretically correct route of using the net present value approach (NPV) all the time. You should learn the process of identifying, analysing and estimating the investment flows, remembering the projections should be in cash not profit flows, unless ARR is being used. Profit flows will need adjustment to cash if only profit estimates are given. You should learn the theory behind the four main analytical techniques with emphasis on why NPV is superior to IRR, PP and ARR. The amount and timing of the net cash flows of a project are crucial to the viability of an investment.

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Given below is an example of two mutually exclusive investments, A and B, with an explanation of why only NPV will give the correct signal to management. Assuming an annual cost of capital of 15% and estimated net actual annual cash flows as stated, then the four methods will give conflicting results. Each method has its own set of decision rules.

Project

Time periods (years) 0 1 5,000 5,000 2 12,500 10,000 3 12,500 (1,000) 4 12,500 Total 17,500 4,000

A B

(25,000) (10,000)

NPV() A B 4,166* 1,251

IRR (%) 22 24*

Payback 2.6 1.5*

(Years) ARR(%) 35* 26.7

Separately using each evaluation method the pairs of values for projects A and B are shown above. Using the NPV approach A will have an NPV of 4166 and B an NPV of 1,251. The decision rule is to select the investment with the higher NPV regardless of the size of the original investment. Therefore A will be preferred to B, which is why it is marked with an asterisk (*). Under each of the evaluation methods and using the appropriate decision rule the preferred choice can be made. It is marked with an asterisk (*) in each case. Using the payback approach would suggest B is preferred as it has the shorter payback period. If one only used ARR, then A is preferred since it has the higher rate. Since neither method is the correct one, it is by chance one gives us the appropriate selection. The main reason for disregarding the outcomes under these two methods is that neither payback nor ARR take into account the pattern of flows (i.e. the time value of the cashflows). Also payback does not take into account the post payback flows which, in the case of A, are considerable, while for B they are less so and it even has a net outflow in one period. From the textbooks note the rationales presented for the still considerable use of payback by managers in practice. See BMM p.202 and PA pp.140143. In the example, though B has the higher IRR, the IRR shown is only one of the two IRRs for that project, the other being a negative value. This is because of one of the technical problems of using IRR that are exemplified in B. For example, B has multiple rates of return because the sign of the annual cash flows changes more than once in the sequence. For each change in sign in the sequence of cash flows, there will be a root to the solution of the equation which produces the IRR. Thus two sign changes, as in B, means two roots to the equation (i.e. two IRRs). Note it is possible that one or more root could be the square root of a negative number which is of no practical value. Also the IRR does not indicate the difference in the size of the projects, 24% of 10,000 is not as good as 24% of 25,000. Another problem is that IRRs reinvestment assumption
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for the fourth year of B is that the funds have been reinvested at 24% to enable comparison with A. This is not necessarily true. From a practical viewpoint, you should learn the capital budgeting process and, in particular, the benefits from the post audit procedure. The post-audit process should involve the comparison of actual results with the predictions for the project and provoke explanations of whatever differences have occurred, thus enabling improved forecasting in the future and improved operations too.

Application problems some considerations

When considering applications of the NPV analysis to practical situations, it is important to ensure that all flows are dealt with on an after tax basis. Similarly, in an inflationary world, when making estimates of cash flows, the specific rates of price increases must be incorporated in the analysis. Wages, raw material prices etc. may be affected by different rates of price changes. In compiling the cost of capital or opportunity cost of funds, we must use the general or average rate of inflation since it is assumed that all providers of funds have the average spending pattern used to compute a retail price index. The cost of capital is the average rate payable to the providers of the capital for the company. The cost of capital is also called the hurdle rate and the opportunity cost of funds (capital). It is called the hurdle rate because it is the minimum that has to be achieved and the opportunity cost because each element of capital has got its own opportunity cost. Therefore, you should prepare all estimates of flows in actual or money terms and then discount the net flows using the actual or money cost of capital. Many businesses are faced with decisions regarding projects that may require repetition on a known cyclical basis. For example, take a business with a fleet of vehicles. Different groups of vehicles in the fleet will need replacement on a regular basis. It is important to identify an optimum replacement period for them. The type and make of vehicle to be used by the group can be identified on cost grounds by use of the net perpetuity value and annual equivalent annuity methods. These are all derived from the NPV approach and can be learnt from BMM (see pp.197199). Finally, businesses have to take investment decisions when their financial resources are limited. Where the capital restriction will only last for one time period (normally one year) the profitability index (PI) should be used to identify the optimal selection of projects. If the restrictions are multi-period and/or multi-faceted (e.g. space or personnel) then linear or integer programming models can be used which maximise the NPV of the portfolio of projects subject to the constraint introduced. An alternative way of acquiring the services of an asset is to lease it rather than buy it. The same principles of evaluation should be applied to the incremental cash flows arising as a result of taking out a lease in order to see whether it is a better way of funding the asset as opposed to buying it.

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Worked example 1 A business is considering an investment in equipment which requires an initial outlay of 10 million. The investment will be allowed a 20% writing down allowance (depreciation) on a straight line basis for tax purposes. It is estimated the equipment will be sold at the end of the project, the end of the fourth year for 3 million. Any tax received on a loss, or paid on a gain, arising from the sale of the equipment would occur in the fifth year. The incremental revenues and costs and the annual price rises incorporated in the estimates arising from the investment are as follows: million Years Sales Wages (4% p.a. increases) Materials (20% p.a. increases) Other costs (5% p.a. increases) Book depreciation Net trading surplus Increases in working capital 10 7 10 2 29 1 1 1 30 11 13 11 2 37 3 0.5 2 40 15 17 12 2 46 4 0.5 3 50 16 19 13 1 49 5 (2.0) 4 4

The business estimates that the average annual inflation rate will be 4.5% p.a. during the five years and the businesss real after tax opportunity cost of capital is 10% p.a. The corporate tax rate for each of the five years is 30% payable a year in arrears. Required: Compute the NPV, IRR, Payback and ARR for the project.

Solution to Worked example 1

First compute the depreciation for tax purposes. Obviously one uses the tax regime requirements appropriate to the country in which one is investing. Writing down allowance computation (straight line) Tax allowance Outlay Year 1 (20%) Year 2 (20%) Year 3 (20%) Year 4 Sale Year 4 10 2 8 2 6 2 4 3 1 2 2 2

Loss on sale

(The same approach can be used for reducing balance based allowances.) Then compute the tax payments or receipts based upon the taxable profits. This may require a transfer of tax depreciation for book depreciation (in this case they are similar).
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Tax computation (million) Years 1 Net trading surplus Add book depreciation Trading surplus (adjusted) Less tax depreciation Taxable profit Tax (30%) 1 2 3 2 1 0.3 2 3 2 5 2 3 0.9 3 4 2 6 2 4 1.2 4 5 1 6 1 5 1.5

Tax is paid in year following the year in which the profits were earned, i. e. tax on year 1s profits of 0.3 paid at end of year 2. Cost of capital (discount rate) (i) The actual or money rate is the rate to use. Then: (1+i) = = Thus i = (1 + 0.1)(1 + 0.045) (1 + 0.1495) 0.15 (i.e. 15%)

(Some authors and businesses use the quick way and get an approximate value by summing the real and inflation rates. Here: 10% + 4.5% = 14.5% = 15%. You should use the theoretically correct method given above unless an approximation is called for.) To calculate the NPV million Year Outlay Trading surplus (adjusted) Working capital change Sale of equipment Tax payments Net cash flows Discount factors (15%) Discounted flows Discount factors (28%) Discounted flows (10.0) 1.0 (10.0) 1.0 (10.0) 2.0 0.8696 1.739 0.7813 1.563 (0.3) 4.2 0.7561 3.176 0.6104 2.564 (0.9) 4.6 0.6575 3.025 0.4768 2.179 0 (10.0) 3.0 (1.0) 5.0 (0.5) 6.0 (0.5) 6.0 2.0 3.0 (1.2) 9.8 0.5718 5.604 0.3725 3.651 (1.5) (1.5) 0.4972 (0.746) 0.2910 (0.437) (0.480) 2.798 1 2 3 4 5 Total (10.0) 20.0 3.0 (3.9) 9.1

The NPV at 15% cost of capital is therefore the aggregate discounted flows of 2.798 million shown above in the Total column. To obtain the NPV note that the accrued profits have been converted into cash flows by the changes in the working capital; that in arriving at the annual flows the specific price changes were used in estimating the wages, materials etc; that the average actual cost of capital had to be calculated and used; that the tax shield is provided by the writing down allowance (tax depreciation) and that tax is paid a year in arrears. (The last point depends on the individual countrys tax regime). All cash flows are

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assumed to arise at the end of the year concerned except for the initial outlay on equipment. The discount factors came from the present value tables and are based on a cost of capital of 15%. The annual discounted flows are computed from the product of the actual net cash flow for a year times its discount factor. (2 0.8696 = 1.739). The row of discounted flows are summed to give the NPV in the final column. Calculation of IRR Using the two discount rates 15% and 28% we have obtained two different NPVs, one positive and one negative. By increasing the discount rate from 15% to 8% an increase of 13%, the NPV declined from 2.798 to a negative 0.180, a total decline of 3.278. The IRR is the rate which gives an NPV equal to zero, so the rate must lie somewhere between 15% and 28%. The reduction in NPV by 2.798 from 2.798 to zero will require increasing the interest rate from 15%. The 13% increase in interest rate produced a 3.278 reduction in NPV. So if the interest rate is increased by an amount equal to the proportion of 2.798 to 3.278 of the 13% it should move from 15% to the appropriate rate which is the IRR. Thus the IRR is
2.798 (28 15) + 15 2.798 (0.480)

= 11.1 + 15 = 26.1% Note: A quicker, but more approximate value could have been obtained by using the NPVs of 9.1 and 2.798 at 0% and 15% respectively. This approach would have given a much less accurate estimate of 21.66% using an extrapolation procedure (check your understanding of the method by doing your own calculation and check with the answer given). Payback Taking the net cash flows: Year 0 1 2 2.0 4.2 6.2 (3.8) 3 Surplus 4.6 0.8 Flows ( million) (10.00)

Payback = 2 + 3.8/4.6 = 2.83 years Accounting rate of return (ARR) Average inflow Average outlay = Total inflow/Project life = Outlay/2 = 19.1/4 = 10/2 = 4.775 =5

ARR = Average inflow/Average outlay

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Profitability Index (PI) PI = NPV Initial investment = 2.798 = 0.28 10.00

Now assume that the business has three other projects it has evaluated. Their characteristics are given below in the table along with those of the project just evaluated. If the four projects were mutually exclusive, then the asterisk indicates the preferred choice under that evaluation method.

Project evaluation table Project A B C D Outlay 10m 25m 15m 15m NPV 2.8m 4.5m* 2.0m 3.0m IRR 26.1% 18.0% 20.0% 26.4%* Payback 2.83 yrs 2.5 yrs 1.9 yrs* 3.0 yrs ARR 96%* 50% 60% 80% PI 0.280* 0.180 0.133 0.200

Conceptually B is the preferred project from amongst the four evaluated because it has the highest NPV of 4.5 million. Using the same data and assuming now that all four projects are available for selection and are not mutually exclusive, then if the business has a maximum of 40 million to invest, the following combinations of projects are possible. The PI is used to indicate the order of selection, starting with project A.

Combination (million) Combination AD AB ADC DB Outlay 25 35 40 40 NPV 5.8 7.3 7.8 7.5 Average PI 0.232 0.209 0.195 0.188

The objective is to maximise the NPV of the portfolio of investments. Here it is assumed that each project is discrete and cannot be split up. The process is to go through the projects, one by one, in descending order of PI, continuing to combine those projects that satisfy the limit placed on available funds. Here the addition of project D to A used the two highest ranked projects and had a 25 million outlay. Third ranked project is B but combining its outlay to A and Ds exceeds the limit, so the project with the next best PI is included that does not exceed the outlay limit. The combination of ADC provides the highest NPV, though some combinations seem to have higher PIs (e.g. AD). However that is a false comparison because the balance of unused funds of 15 million should be included with its zero NPV, thus giving a lower corrected average PI of 0.145. If it is assumed that all projects could be undertaken fractionally if necessary, then the combination would have been A, D and 3/5 of B, derived as follows by using the PI ranking:

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Project A AD 3/5B

PI 0.322 0.200 0.180 0.2125

Outlay 10 15 3/5 25 40

NPV 2.80 3.00 2.70 8.50

Try and understand the applied type problems and examples used in the texts, in particular those in BMM. Understand the conceptual weaknesses and strengths of theoretical methods used and learn how to critique your methods and results.

What-if questions
Now that youve learnt the basic techniques for the analysis of investment proposals, on the assumption of operating in a world of certainty, relax that assumption and consider that in the real world, fewer things will actually occur than might have been predicted. Managers need to evaluate the effects of these possibilities in their initial prediction. There are various ways of doing this. The first is by the use of sensitivity analysis. This requires an estimate of the effect on the predicted outcome, usually NPV, of changes in each variable. Effects of changes of combinations of variables can also be evaluated. It can be identified from this evaluation those variables whose changes might influence the outcome the most. Arising out of that identification, managers can assess the likelihood of the variable change, and whether it can be influenced by managerial efforts. The overall impact on the final outcome of the potential changes can be evaluated and aid the decision as to whether or not the proposal can be accepted. An extension of sensitivity analysis is breakeven analysis which can be used to assess the magnitude of change that will reduce the originally predicted NPV to zero separately for each variable. When a number of variables are interrelated, then the different combinations can be reviewed as separate possible scenarios. This is called scenario analysis, for example, managers may call for three different but consistent combinations of variables, one is the set of the most optimistic outcomes, another the set of most likely and the third, the set of the most pessimistic outcomes. This is sometimes called three-point estimates. An extension of this approach, calling for a more sophisticated knowledge of probability distributions of outcomes, is called simulation analysis.

The examination
Extracts from discount and annuity tables will be supplied in the examination for unit 59 Financial management if these are

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relevant for any question. You can however use your own calculator to generate the factors if you so wish.

A reminder of your learning outcomes

By the end of this chapter and having completed the essential reading and activities, you should be able to: describe and apply the time value of money in project evaluation, whether it be future or present value oriented defend the use of NPV as the method of appraisal against other suggested methods prepare evaluations of investment proposals and state which decision rule is appropriate in the specific set of circumstances.

Sample examination questions

1. What is the time value of money? 2. Discuss the pros and cons of NPV, IRR and payback period as methods of appraising investments. 3. Make a case to support the reported managerial preference for the use of IRR and payback methods in real world situations.

Practise question 2.1

Snowdon plc has a fund of 15million to invest in new projects. It has a number of proposals to consider. The first proposal, A, is a large proposal requiring an initial investment of 13million in plant and equipment which at the end of the projects life of 4 years will have a resale value of 4.0million. The company has 100,000 still to pay to the consultants under the research and development contract for this project of 3million. The contractual obligation will be met in 3 months time. A working capital fund of 2million will be needed immediately to finance the build up of stock and debtors. At the end of the projects life only 1.8million will be recovered when stocks of the product are rundown and debtors pay up. The life cycle predictions for sales volumes, prices and variable costs are as follows:

Years Sales volume (000) Sales price/unit () Variable cost/unit()

1 1200 20 4

2 1920 20 4

3 960 18 4

4 600 13 4

The incremental fixed costs were forecast to remain constant over the products life which for the annual production fixed overheads were 4.15million p.a. and administration and selling were

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8.20million p.a.. In calculating these fixed overheads the accountant had included 3.25million p.a. for the annual depreciation write off of the new equipment. The company has a cost of capital of 15%.

REQUIRED (a) Calculate the payback period and accounting rate of return for project A. (b) Calculate the net present value to the company of project A. See VLE for solution

Problems
In BMM attempt the following problems: Chapter 7, pp.2047, numbers 15, 19, 20, 25, 27 and 30 Chapter 8, p.234, numbers 18 and 25 Chapter 9, p.258, numbers 5 and 6.

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Notes

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