INVESTMENT APPRAISAL TECHNIQUES FOR SMALL AND MEDIUM SCALE ENTERPRISES

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SAMUEL ADEGBOYEGA UNIVERSITY COLLEGE OF MANAGEMENT AND SOCIAL SCIENCES DEPARTMENT OF BUSINESS ADMINISTRATION COURSE CODE: BUS 413 COURSE TITLE: SMALL AND

1 SAMUEL ADEGBOYEGA UNIVERSITY COLLEGE OF MANAGEMENT AND SOCIAL SCIENCES DEPARTMENT OF BUSINESS ADMINISTRATION COURSE CODE: BUS 413 COURSE TITLE: SMALL AND MEDIUM SCALE ENTERPRISE MANAGEMENT SESSION: 2017/2018, FIRST SEMESTER. LECTURER: DR M. OSEMEKE INVESTMENT APPRAISAL TECHNIQUES FOR SMALL AND MEDIUM SCALE ENTERPRISES

2 INVESTMENT APPRAISAL TECHNIQUES FOR SMALL AND MEDIUM SCALE ENTERPRISES INTRODUCTION Investment contemplation is a long term consideration and decision where expenditure and investment options are balanced in the expectation that investment now will generate extra returns in the future. This topic examined the wide range of criteria for evaluating the usefulness of investment evaluation methods and describe the ways inflation and taxation affect project appraisal

3 Learning Objectives: After studying this topic, the reader should be able to know about: Investment evaluation techniques Capital investment techniques, Other variables that affect investment appraisal techniques Summary and conclusions Revision Questions

4 Investment Evaluation Technique Two categories of evaluation techniques are used: 1.the traditional project evaluation technique 2. the modern testing technique

5 Traditional Evaluation Technique This technique is divided into two: simple payback method use of ratios. (a) simple payback method. In the simple payback method, adds up the forecast net cash inflows on a year-by-year basis until the amount of the initial capital investment is reached, which gives the years to payback. Weakness of this method: It is an inadequate technique for evaluating project because standard and original capitals vary tax is not deducted and tax allowances are obscure it cannot cope with inflation and takes no account of later profits if any Besides, whether any profit is made on the investment is not measured at all. (b) Use of Ratios: This involves balance sheet ratios for current and proposed operations. Such ratios include: profit to sales ratios capital employed ratio current assets, working capital etc. Merits of this technique: The ratios are useful for regulating smooth operations but are useless in judging profitability, owing to definition problems and choice of standard, and mostly because the time worth of cash is absent

6 Course content Cont d (b) Use of Ratios: This involves financial statement ratios for current and proposed operations. Such ratios include: profit to sales ratios capital employed ratio current assets, working capital etc. Merits of this technique: The ratios are useful for regulating smooth operations Demerits useless in judging profitability, owing to definition problems and choice of standard, the time worth of cash is absent

7 Modern Investment/Project Evaluation Technique This evaluation technique takes into consideration the instant worth of money. It makes the modern analysis technique more reliable and acceptable. It concentrates on incremental cash flow of a project. The cash flow is discounted at the projects' discount rate to the present time, giving the present value. One of the techniques involved under this subhead is referred to as DCF (discounted cash flow). The DCF overcome some of the disadvantages of the traditional techniques DCF has problems and contains many assumptions so that it should be used with care and with an awareness of its limitation The main DCF techniques of NPV and IRR are described below but first lets consider features common to all DCF methods: These are the use of cash flows, the time value of money, and the assumptions in basic DCF appraisal.

8 Contents Cont d Use of Cash Flows: - DCF methods use cash flows and not accounting profits. For investment appraisal purposes a project oriented approach using cash flows is to be preferred for the following reasons: Cash flows are more objective and in the end is what actually counts. Accounting conventions regarding revenue/capital expenditure classifications, depreciation calculations, and stock valuations are unnecessary. The entire life of the project is to be well thought-out; hence accounting profits, linked to periods are not considered.

9 Contents Cont d Time Value of Money Investment evaluation is concerned with long-run decisions where costs and income arise at intervals for a time.. Both discounting and compounding methods allow for the instant worth of money and could accordingly be used for investment appraisal, but on the whole discounting methods are more frequently used. It should be noted that the time worth of funds concept applies despite that there is zero inflation, which increases the discrepancy in value between monies received at diverse times.

10 Contents Cont d Assumption in Basic DCF Appraisal In describing the main DCF methods, certain assumptions are made These are: there is no Uncertainty there is no Inflation The appropriate discount rate to use is known A perfect capital market exists i.e. unlimited funds can be raised at the market rate of interest.

11 Capital Investment Evaluation Technique A capital investment represents an investment in long-term assets and relatively large size. It has a period of more than one year and collapses between initial investment and returns. The foremost option of Evaluation of project feasibility are: i. Accounting Rate of Returns (ARR) ii. iii. iv. Payback Periods Net Present Value (NPV) iv. Internal Rate of Return (IRR)

12 Accounting Rate of Returns (ARR) This is the ratio of average annual profits, after depreciation, to the capital invested. NOTE: profits may be before or after tax, - capital may or may not include working capital, - capital provided may even mean the initial capital outlay or the average of the capital devote over the life of the project. Another phrase is Return on Capital Employed (ROCE). The formula for calculating Accounting Rate of Return on investment (ARR) is: ARR = Average Annual Accounting Profits X 100 Initial Capital Invested Here, profit means accounting profits as in comprehensive financial statement; that is after depreciation but before tax. Initial capital is the outlay of a fresh project or written down value of an existing project. An alternate method is: ARR = Average Annual Accounting profits X 100 Average Capital Invested

13 Accounting Rate of Returns (ARR) Cont d Here, Average capital invested is equal to the initial capital plus the residual value of the investment divided by two. Note that where there is no residual value, substitute zero in the formula i.e. initial capital divided by two. It is important to note that ARR uses accounting profit and not cash flow. (A) Where inadequate projects are involved, accept all projects with ARR in excess of the target ARR and reject all those below the target ARR. (B) Where mutually exclusive projects are involved (that is choosing between projects A OR B) chose the project with the higher accounting rate of return provided it is more than the target rate of return.

14 EXAMPLE OF ARR Illustration I: A hypothetical firm has N100,000 to invest in a project. The projected profits after depreciation for 5 years duration of the projects are first 3 years, N30,000 each year, 4th year N50,000 and 5th year N20,000. Required: Determine the ARR by means of (a) initial capital (b) Average capital

15 SOLUTION TO ILLUSTRATION 1 ARR = Average Annual Accounting Profits x 100 Initial Investments 1 Average profit = 160,000 = N Initial Capital = N100,000 ARR = X 100 = 32% 100,000 1

16 Using average capital ARR = Average Annual profit x 100 Average Annual Capital Invested 1 Average Annual Profits = Average Investments = 100,000 2 = N50,000 :. ARR = x 100 = 64% 50,000 1

17 Advantages and Disadvantages of ARR Advantages: it is simple to calculate. It depends on accounting information, which is readily available and familiar to investors. It facilitates post auditing of capital expenditures. Disadvantages Timing of outflows and inflows are not permissible. Utilized to determine the return of the concept of accounting proceeds. This is not as suitable for investment evaluation function as the cash flows generated by the project. There are numerous measures of accounting rate of problems in interpretation. The ARR method can be highly misleading because balance sheet book values reflect neither the earning capacity of assets nor their market values. No universally accepted method of calculating ARR

18 Payback Period Technique Definition Payback can be defined as the period, generally expressed in years that it takes to enable the project's net cash inflows to make good the original investment. It can be used as a basis for accepting or rejecting a simple project or to rank projects. It is a measure of product liquidity and capital recovery rate rather than its profitability. A project is considered potentially attractive if it is expected to break-even point within the repayment period; and unattractive if it is not. Until break-even points are reached, the returns from the project are merely contributing towards the payment of the money that has been put into it. In payback period, the investor decides upon the actual period of time during which the projects must reach its break-even point. Payback methods are of two categories: - simple payback, where the time is generally articulated in years that it takes the cash inflows from a project to be identical to cash outflows i.e. the length of time it takes the project to recuperate the investment. Payback method with salvage value:' where payback is a whole number of years, scrap values cannot be apportioned to months, and scrap values are not cumulative

19 Decision Rule For independent project, accept all those projects with payback time less than maximum mandatory actual payback, otherwise reject. For a mutually exclusive projects choice situation, choose the project with the smaller pay off time provided it does not exceed maximum or target period

20 Advantages and Disadvantages of Payback period Advantages: i. It is easy to determine and comprehend. ii. iii. iv. Uses project cash flows rather than accounting profits and hence is more objectively based. Favour quick return projects which may produce faster growth for the company and enhance liquidity. Choosing projects with quick payback time will tend to minimize risks facing the corporation, which are related to time. Disadvantages i. This evaluation method cannot take into account the cash flow subsequent to the repayment period; thus, in general it does not decide profitability of the venture. ii. iii. In this evaluation method time value of money is not detected. In this evaluation method risk is not detected.

21 Illustration II: A hypothetical firm has N100,000 to invest in a project of N30,000 for the 1 st 3 years, N50, for year 4 and N20,000 for year 5 and a scrap value of N35,000, N25,000, N15,000, Nl0,000 and NIL for 1-5 years respectively, Required: Using the simple payback method and payback with salvage value, calculate the payback.

22 Solution II: Exhibit I Calculation of back Period Year Cash flow Cum. Cash Scrap value 0 100, ,000 30,000 35,000 65, ,000 60,000 25,000 85, ,000 90,000 15, , , , , Cum. Cash flow & Scrap value Source: Author s Computation 2018 Simple payback computation = 3 years X 12 months = 3 years 2.4 months 50,000 Payback with salvage value is 3 years.

23 Net Present Value Method (NPV) Definition: The current worth of all money inflows less the current value of money outflows is referred to as NPV of that particular venture. To evaluate the NPV, the following is required: i. Designate the cash inflow as positive cash flows. ii. iii. iv. Designate the cash outflow Discount to set present value and Sum up all the discounted outflows. Decision rule: i. Accept projects if NPV is greater than 0 ii. Reject projects if NPV is less than 0 This applies to independent projects where you accept or reject the rule. Mutually exclusive projects where one has a choice to choose project A OR B, choose the project with the higher NPV so long as NPV is greater than zero.

24 Advantages and Disadvantages of NPV method : The Benefits are: i. It distinguishes the time value of money. ii. It measures in absolute terms the changes (increase or decrease) in shareholders wealth. iii. Under situation of capital rationing NPV gives added reasonable solution than the IRR to a problem of deciding on mutually exclusive projects. Disadvantages The disadvantage of this practice is that risk is not detected; it relies considerably on the accurate approximation of the cost of capital. Steps in Calculating the NPV (a) Calculate the annual cash flow (b) Discount the individual cash flows to their present values. (c) Add up the present value, thereafter (d) Subtract the initial capital outlay from the summation.

25 Illustration III Assume that Osems Ventures Ltd, a hypothetical firm intends to invest on a project with a capital cost of N10,000, cost savings per year for three years (total N15,000). Required: compute the NPV and a Discount Factor (DF) of 10%, make decision whether to accept the project or not to accept the project.

26 Solution iii: Calculation of Net Present Value Source: Author s Computation 2018 Year Cost Savings (cash flow) Present Value Factor Present Value 0 N10,000 1 (N10,000) 1 5, , , Net Present Value 2435 Decision: Accept Project since the NPV of N2435 is greater than zero.

27 Solution iii Cont d NOTE: (a) At the point of investment, the total capital expenditure is considered as a cost or loss; hence it is put in bracket. (b) The discounting factor is a whole number; since, at the point of investment, the worth of the money being used, in this case the Naira has not been affected by depreciation or inflation. (c) The discounting factor is accessible from the NPV tables. Calculators may also be used to calculate them in the absence of tables. (d) The summation of the cash flows was N12435; so when we deducted the initial capital outlay of N10,000 we arrived at N2435 which represents the NPV for the project. (e) When the NPV is in affirmative, as it is in the figure above, the project is feasible and should be accepted and vice versa.

28 Internal Rate of Return (IRR) Definition DCF yield, trial and error method, and discounted yield are additional names for IRR. This is defined as the discount rate, which provides nil NPV when applied to the project cash flows. Mathematically IRR or the DCF rate is the rate at which the interest rate will cause the NPV to turn out to be Nil. However, two methods are used to calculate IRR: (a) by graph method ( also known as a current value report) (b) by linear interpolation. Both methods are illustrated below. Decision rule: when the calculated IRR is superior to the company's rate of capital then the scheme is adequate given the assumptions already mentioned otherwise reject Note: IRR is not only the interest rate that causes the NPV of cash flow stream to be zero, but is also the interest rate that causes exact recovery throughout the duration of the venture plus return on the un-recovered investment balance

29 Advantages & Disadvantages of IRR Advantage of IRR i. The IRR captures the time value of money ii. It is easy to understand particularly by non-financial managers who are familiar with the rate of return approach. iii. It is a good measure of the margin of safety in cases where there have been errors in the estimation of charges on capital of the cost of capital. Disadvantage of IRR i. Risk in IRR is not detected ii. The magnitude of the initial outlay is not reflecting on. iii. Where a scheme has an alternative outflows there may be no real solution to the IRR iv. It may not provide the correct solution i.e. the optional investment decision using investment rationing explanation. v. Where mutually exclusive projects have to be considered, the IRR might categorize projects in a different way from the ranking given by NPV. vi. The IRR decision rule breaks down when confronted with changing price of capital in future years.

30 Illustration IV: An investment is being considered for which the net cash flows have been estimated as follows: Year 0 = N9500, year 1 = N3000Year 2 =N4700 Year 3 = N4800, year 4 = N3200 What is the IRR if the Discount Rate is 20%. Use both methods for the solution.

31 Solution IV: Calculation of IRR (Graph Method) Year Cash flow DF20% PV DF25% PV 0 (N9500) (9500) (9500 ) NPV Source: Author s Computation 2009 Using the present value profile, it is normal to plot at least two points, one at a rate, which gives a positive NPV of N582 at 20%, and the negative NPV of N-322 at 25% as indicated below:

32 Solution IV: Cont d Source: Author s Drawing 2018 Note: that a discount rate must be chosen which gives negative NPV so that the PV stripe pass through the horizontal axis. Also the PV stripe pass through the axis at approximately 23%, which is a close enough estimate for most practical decision making purposes

33 Solution iv Cont d Finding the IRR by linear interpolation A formula for making this calculation referred to as interpolation is: Where: A is the discount value which provides the positive NPV a is the amount of the positive NPV, B is the discount rate, which provides the negative NPV b is the amount of the negative NPV but the minus sign is Ignore

34 IRR Cont d Comparison of NPV and IRR NPV is technically superior to IRR and is simpler to calculate Where cash flow patterns are non-conventional there may be nil or several internal rates of returns making the IRR impossible to apply. NPV is superior for making investments decision in order of alternativeness. With conventional cash flow patterns both methods provide similar accept or reject decision. Where discount rates are expected to differ throughout the duration of the project such variations can be readily incorporated into NPV calculations, but not in those for the IRR. Notwithstanding, the technical advantages of NPV over IRR, IRR are widely applied so that it is essential that students are aware of its inherent limitations..

35 Profitability Index The other variables that affect investment appraisal techniques discussed here is profitability index. The Profitability Index is purely an alternative to the essential NPV technique and is the ratio of the NPV of a project to the initial investment. i.e. EVPI = Net Present Value (NPV) Initial Investment Thus the index is a determinant of relative and not absolute profitability. Projects can be ranked in order of their EVPI and implemented in order of attractiveness until the capital available is exhausted. In general, the EVPI is of limited usefulness and the use of NPV is considered safer.

36 SUMMARY The focus of this topic is on investment appraisal techniques for approval or refusal of investment options existing at both the private and public sector project sponsors. The traditional investment appraisal techniques are the ARR and payback. Payback is shown to be generally used method. It is the number of period s cash flows recoups the original investment. The project preferred is the one with the smallest payback period. The modern investment appraisal techniques-discounted cash flows techniques (NPV and IRR) use cash flows rather than profits and take account of the time value of money. IRR is the discount rate, which gives zero NPV and can be found graphically or by linear interpolation. Excess Present Value Index (EVPI) or profitability Index as an expansion of NPV. Finally NPV is a very suitable measurement for selecting between mutually exclusive projects and is universally is precisely superior to IRR.

37 Revision Questions (1) Discuss the concepts and the steps in calculating the Net present value (NPV) technique of a project and state the decision Rule. (2) What are the assumptions in the Discounted Cash Flow (DCF) Appraisal Method and why the use of Cash Flows? (3) Define NPV and state the basic formula. (4) Define Internal Rate of Return (IRR) and how is it computed? (5) Distinguish between NPV and IRR (6) Explain the meaning of Profitability Index and when can it be effectively used?

38 Reference Materials Lucey, T, (1996). Management Accounting: London DP publications. Nwoye, M.F (2007), Small Business Enterprises (How to Start and Succeed); Benin City, Uniben Press Olowe R. A (2008) Financial Management: Concepts, Financial System and Business Finance. Lagos Briery Jones Nig. Ltd. Pandey I. M. (2007), Financial Management: 9 th Ed: New Delhi. Vikas Publishing,

Commercestudyguide.com Capital Budgeting. Definition of Capital Budgeting. Nature of Capital Budgeting. The process of Capital Budgeting

Commercestudyguide.com Capital Budgeting Capital Budgeting decision is considered the most important and most critical decision for a finance manager. It involves decisions related to long-term investments