The nature of investment decision

Transcription

1 The nature of investment decision Investment decisions must be consistent with the objectives of the particular organization. In private-sector business, maximizing the wealth of the owners is normally assumed to be the key financial objective. Investment involves making an outlay of an economic value (cash) at one point in time, which is expected to yield economic benefits to the investor at some other point in time. Thus, time is the essential feature of investment decisions. This outlay is typically a single large amount while the benefits arrive as a series of smaller amounts over a fairly protracted period. The reasons behind the importance of investment decisions to the business; - Large amounts of resources are often involved: Many investments made by businesses involve laying out a significant proportion of their total resources. If mistakes are made with the decision, the effects on the businesses could be catastrophic. - It s difficult and expensive to bail out of an investment once it has been undertaken: It means that the amount recouped from the investment is much less than it had originally cost, in such cases where investment decision found to be limited with a resale value. It is essential that proper screening of investment proposals takes place. An important part of this screening process is to ensure that appropriate methods of evaluation are used. There are basically four methods used by businesses to evaluate investment opportunities. - Accounting rate of return (ARR). - Payback period (PP). - Net present value (NPV). - Internal rate of return (IRR). Most businesses use one or more of these four methods. Large business seems to be more sophisticated in their choice and use of appraisal methods than smaller one, where they rely on their manager s gut feeling. We are going to assess the effectiveness of each of these methods except the ARR method (not required). Payback period (PP) Payback period (PP) is the length of time that it takes for the cash outflow for the initial investment to be repaid out of resulting cash inflows. The decisions rules needed to be applied in using the PP method are; - Project should have a payback period no longer than a maximum payback period set by the business. - Where there are competing projects, the one with the shortest PP should be selected. The logic of using PP is that projects that can recoup their cost quickly are economically more attractive than those with longer payback periods. In other words, it emphasizes liquidity.

2 How to calculate the payback period Let us consider PP on the context of the Billingsgate Battery; Time Net cash Cumulative cash Immediately Cost of machine (100) (100) 1 years time Operating profile before depreciation 20 ( ) = (80) 2 years time Operating profile before depreciation 40 (-80+40) = (40) 3 years time Operating profile before depreciation 60 (-40+60) = 20 4 years time Operating profile before depreciation 60 (20+60) = 80 5 years time Operating profile before depreciation 20 (80+20) = years time Disposal proceeds 20 (100+20) = 120 We can see that the cumulative cash flows become positive at the end of the third year, had we assumed that the cash flows arise evenly over the year, the precise payback period would be: 2 years + (40/60) years = 2⅔ years Where 40 represent the cash flow stull required at the beginning of the third year to repay the initial outlay and 60 is the projected cash flow during the third year. (Solve activity 14.5 Page 551) Advantages of payback period method; - Takes time into account. - Quick and easy to calculate. - Easy to understood by managers. Disadvantages of payback period method; The PP investment appraisal would view several projects as being equally attractive, ignoring the cash flow generated in the later years. (For further explanation Check Activity 14.6 & Figure14.1 Page 551/552). - It takes little account on the timing of cash flows; any cash flows arising beyond the payback period are ignored. This means that not all relevant information may be taken onto account. - It does not provide clear signals; by favoring projects with a short payback period, it looks only at the risk that the project will end earlier than expected ignoring other risk areas such as the customer demand, therefore it can be Impractical to use. - It does not relate to shareholders wealth; it s not concerned with maximizing the wealth of the business owners instead of favoring projects that pay for them quickly. - It does not provide the accurate payback period; it s a matter of judgment hence managers must select the required payback period as this cannot be objectively determined. The maximum period can vary from one business to the next.

3 Net present value (NPV) Net present value (NPV) is the sum of the discounted values of the net cash flows from the investment. NPV considers all of the costs and benefits of each investment opportunity and makes a logical allowance for the timing of those costs and benefits. The decisions rules needed to be applied in using the NPV method are; - Project should have positive NPV to be accepted; if it is negative the project should be rejected. - Where there are competing projects, the one with the higher NPV should be selected. Time is an important issue because people do not normally see an amount paid out now as equivalent in value to the same amount being received in a year s time. Therefore, the cash outflow will occur immediately, whereas the cash inflows will arise at different times. This is due to the below reasons; - Interest lost Investments must exceed the opportunity cost of the funds invested to be worthwhile. Opportunity cost is where one course of action deprives us of the opportunity to derive some benefit from an alternative action. If Billingsgate Company sees putting the money in the bank on deposit as the alternative to investment in the machine because the returns would be better, there is no reason to buy machine. - Risk premium All investments expose their investors to risk, Therefore investors must decide whether to accept the risk that things will not turn out as expected on exchange for the opportunity to generate wealth. Billingsgate Company expects much greater returns from buying the machine than investing in the bank deposit because of the much greater risk involved. - Inflation Inflation is the loss in the purchasing power of money which occurs overtime. Investors will expect to be compensated for this loss of purchasing power. Interest rates observable in the market tends to take inflation into account such as bank depositors include an allowance for the expected rate of inflation. To sum up, Logical investors seeking to increase their wealth will only invest when they believe they will be adequately compensated for the loss of interest, for the loss in the purchasing power of money invested and for the risk that the expected return may not materialize. This normally involves checking to see whether the proposed investment will yield a return greater than the basic rate of interest (which will include an allowance for inflation) plus an appropriate risk premium. Using logic to derive the PV of a cash flow expected after one year can be calculated with the below formula; PV of the cash flow of year n = actual cash flow of year n / (1 + r) n Where n is the year of the cash flow (how many years into the future), and r is the opportunity financing cost expressed as a decimal. (For further explanation Check Activity 14.9 Page 557).

4 How to calculate the Net present value Let us consider PP on the context of the Billingsgate Battery with rate of 20 per cent a year; Time Net cash Calculation of PV PV 000 Immediately Cost of machine (100) (100) / ( ) 0 (100) 1 years time Operating profile before depreciation / ( ) years time Operating profile before depreciation / ( ) years time Operating profile before depreciation / ( ) years time Operating profile before depreciation / ( ) years time Operating profile before depreciation / ( ) years time Disposal proceeds / ( ) The business would logically be prepared to pay up to $ since the wealth of the owners of the business would be increased up to this price although the business would prefer to pay as little as possible. Using present value tables Discount factors values for the range of values of r and n are shown in such tables (Page 810/811). These kind of tables show how the value of 1 diminishes as its receipt goes further into the future. (For further explanation Check Activity 14.12/14.13 & Figure14.3 Page ). The discount rate and the cost of capital The appropriate discount rate to use in NPV assessments is the opportunity cost of finance, which is in effect, the cost to the business of the finance needed to fund the investment. It will normally be the cost of a mixture of funds (shareholders funds and borrowings) employed by the business, this called (cost of capital). Advantages of Net present value method; NPV offers a better approach to appraising investment opportunities that PP, due to the below reasons; - Takes account of the timing of the cash flows; it considers the time value of money and the discounting process incorporates the opportunity cost of capital. - Takes all relevant information into account; It includes all of the relevant cash flows which are treated according to their date of occurrence. - Relates directly to shareholders wealth objectives; its output has a direct bearing on the wealth of the owners of the business (the only method). - Provides the basis for valuing economic assets; this assets have the capability of yielding financial benefits such as equity shares & loans. Economic value is the value derived by adding together the discounted (present) values of all future cash flows from the asset concerned.

5 Internal rate of return (IRR) Internal rate of return is the discount rate that, when applied to its future cash flows, will produce an NPV of precisely zero. The decisions rules needed to be applied in using the IRR method are; - Project must meet a minimum IRR requirement to be accepted. This is often referred to as the hurdle rate and, logically, this should be the opportunity cost of capital. - Where there are competing projects, the one with the higher IRR should be selected. IRR cannot usually be calculated directly. Iteration (trial and error) is the approach normally adopted. Doing this manually is fairly laborious. In IRR, no account is taken of the time value of money. However, as the discount rate increases there is a corresponding decrease in the NPV of the project. When the NPV line crosses the horizontal axis there will be a zero NPV. This point represents the IRR. (Check Figure14.4 page 563). How to calculate the Net present value In order to calculate the change in NPV arising from a 1 per cent change in the discount rate we need to take the difference between tow trails, (that is 15 % and 10 % which already carried out in activities 14.12/14.15) Trial Discount factor % NPV (23.49) 2 10 (2.46) Difference The change in NPV for every 1 percent change in the discount rate will be (21.03/5) = 4.21, In such case of activity page 564 where the NPV value is 2.46 for the 10 % discount rate. The amount by which the IRR would need to fall below the 10% discount rate in order to achieve a zero NPV would be: Therefore the IRR will be: Advantages of Internal rate of return method; [2.46/4.21] x 1 % =.58 % ( ) = 9.42 % - Takes time into account. - Takes all relevant information into account. - It represents the yield from an investment opportunity. - It s related to NPV method in that both involve discounting future cash flows. Disadvantages of Internal rate of return method; - It does not relate directly to shareholders wealth; usually gives the same signals as NPV but can mislead there are competing projects of different size. - Ignores the scale of investment; accepting the project with the higher percentage return will often generate more wealth which could be not the case, So does ARR. - Difficulty in handling projects with unconventional cash flows; project may have both positive and negative cash flows at future points in its life witch make IRR difficult to use.