MANAGEMENT OF FINANCIAL RESOURCES AND PERFORMANCE SESSIONS 3& 4 INVESTMENT APPRAISAL METHODS June 10 to 24, 2013 CA. Sonali Jagath Prasad ACA, ACMA, CGMA, B.Com. WESTFORD 2008 Thomson SCHOOL South-Western OF MANAGEMENT 1
Session Learning Outcome Understand how to use appraisal methods to manage financial resources
Session -Takeaways Evaluate how to assess strategic investment opportunities Understand what input data or information is relevant for the assessment Understand the rationale and interpretation of investment evaluation methods Learn how to analyse investments and justify recommendations
I. INVESTMENTS
Investment Objectives Manufacturing Company Investment in fixed assets : Sales growth through enhanced capacity Product diversification through launch of new products Replacement of old plant and machinery Improve process/cost efficiencies Financial Investment Set up a joint venture Take strategic stake through new venture or an acquisition Deployment of surplus funds to generate income Finance/Investment Company Return on investment to generate profit Risk diversification/reduction
Types of Investments Long-term Investments Investment in Fixed Assets Investment in joint ventures Market investments Equity Shares Bonds Mutual Funds/ Hedge Funds Short-term Investments Bank fixed deposits Money market mutual funds
Concept of Risk Risk is defined as uncertainty regarding the outcome of an event For an investment or project, Risk can be visualised as to how much does the returns or profits or cash flows deviate from expected Therefore, Risk is normally measured as the standard deviation of actual returns from its mean or expected value For a company, the business risk is the variability of the firm s earnings An investment which is listed on the stock markets, it faces two types of risks: Systematic Risk Risk due to the whole stock market, external to the company Unsystematic Risk Risk due to factors specific to the Company, unrelated to the markets
Concept of Return Return is income received by an investor on an investment. Rate of return is expressed as percentage of the principal amount invested. The amount of return on an investment is a function of three things: Amount invested Length of time that amount is invested, and The rate of return on the investment Rates of return are always quoted as annual rates The formula for the annual rate of return is: Return received for one year s investment / Amount invested
What is The Time Value of Money? A dollar received today is worth more than a dollar received tomorrow This is because a dollar received today can be invested to earn interest The amount of interest earned depends on the rate of return that can be earned on the investment Time value of money quantifies the value of a dollar through time 9
Present value What is the Present Value (PV) of the previous problem? The Present Value is simply the $1,000 you originally deposited. That is the value today! Present Value is the current value of a future amount of money, or a series of payments, evaluated at a given interest rate.
Present Value of a Cash Flow Stream A cash flow stream is a finite set of payments that an investor will receive or invest over time. The PV of the cash flow stream is equal to the sum of the present value of each of the individual cash flows in the stream. The PV of a cash flow stream can also be found by taking the FV of the cash flow stream and discounting the lump sum at the appropriate discount rate for the appropriate number of periods. 11
Example of PV of a Cash Flow Stream Joe made an investment that will pay $100 the first year, $300 the second year, $500 the third year and $1000 the fourth year. If the interest rate is ten percent, what is the present value of this cash flow stream? 1. Draw a timeline: $100 $300 $500 $1000 0 1 2 3 4???? i = 10% 12
Example of PV of a Cash Flow Stream 2. Write out the formula using symbols: n PV = S [CF t / (1+r) t ] t=0 OR PV = [CF 1 /(1+r) 1 ]+[CF 2 /(1+r) 2 ]+[CF 3 /(1+r) 3 ]+[CF 4 /(1+r) 4 ] 3. Substitute the appropriate numbers: PV = [100/(1+.1) 1 ]+[$300/(1+.1) 2 ]+[500/(1+.1) 3 ]+[1000/(1.1) 4 ] 13
Example of PV of a Cash Flow Stream 4. Solve for the present value: PV = $90.91 + $247.93 + $375.66 + $683.01 PV = $1397.51 5. Check using a calculator: Make sure to use the appropriate rate of return, number of periods, and future value for each of the calculations. To illustrate, for the first cash flow, you should enter FV=100, n=1, i=10, PMT=0, PV=?. Note that you will have to do four separate calculations. 14
Data Required for Investment Evaluation Investment in Machinery Cash Outflow for investment Purchase value Installation cost In case of replacement, sale value of old equipment Cash Inflow Annual cash Profit Adjusted for working capital increase or decreases Terminal salvage value Financial Investments Investment cash outflow Annual interest/dividend Final market/redemption value Discount Rate Cost of Capital
Key Issues Only use relevant income and costs Factors to consider Economic Industrial Firm wide inputs Take due care in using historical performance as an indicator of future performance Consistently use either nominal or real earnings and expenses Allocation of overheads should be down judiciously Proper estimation of repairs and maintenance expenses Capture life of project appropriately and account for salvage value Working capital requirements to be captured correctly, as practicable Cost of funding the project to take into account the firm s cost of capital
II. INVESTMENT EVALUATION
1. Project appraisal / Capital Budgeting
When do you use Capital Budgeting? When there is a limitation of capital When decisions need to be taken on: Buying a new equipment Lease v/s purchase Undertaking an expansion project Cost reduction investment Decision to replace equipment now or later Enhance profitability Capital budgeting process Identify projects Determine capital available Set-up hurdle rates or benchmarks Calculate project returns or profitability above threshold Rank projects as per selected criteria Select appropriate projects
How to Evaluate Capital Investments
Payback Method Measures the time required for a project to recover its initial cost How to calculate Payback? Calculate Initial Investment and Annual Cash Inflows Cumulate Cash Flows Payback is the time taken for the cumulative cash flow to reach zero indicating initial investment has been paid back Rule of evaluation If Payback period is below hurdle period, accept the project If Payback period is above hurdle period, reject the project Analysis of Payback Method Quick and easy to calculate Rough and ready indicator of risk However, does not consider time value of money Ignores cash inflow post the payback period Ignores cost of capital
Payback Method - Example Estimate the Payback period for a project which calls for an initial investment of $ 100,000 and an annual post tax cash flows of $ 30,000 for five years. Answer: Roughly, payback period is between 3 and 4 years Accurately, Payback Period = Beginning of gap year + (Gap to be covered) / Annual cash flow in gap year = 3 + 10,000 / 30,000 = 3.33 years
Net Present Value NPV Method NPV measures the cash flows of a project net of initial investment NPV = PV of Cash Inflows Initial Investment Rule of evaluation If NPV is positive, accept the project If NPV is negative, reject the project What should be the discount rate that is to be used? Overcomes some of the disadvantages of payback method: Considers time value of money Gives weightage to initial investment Key Issues with NPV Gives an absolute numbers making it difficult to rank projects
NPV Method - Example Estimate the NPV for a project which has the cash flows as per the following table and using a discount rate of 10% Answer: NPV = PV of Cash Inflows Initial Investment = (18,182 + 28,296 + 37,566 + 40,981 + 46,569) 100,000 = $ 72,223
Internal Rate of Return IRR Method Measures the rate of return of a project Conceptually, IRR is the discount rate at which the NPV is zero IRR can be calculated as the rate r in the following equation Initial Investment = (CFt/(1+r)n) Rule of evaluation If IRR is greater than hurdle rate, accept the project If IRR is lesser than hurdle rate, reject the project IRR has issues which merit consideration Assumes intermediate cash flows are re-invested at the same rate as the IRR Projects with alternating positive and negative cash flows can throw up more than one IRR To overcome the above issues with IRR, one can use Modified IRR MIRR
IRR Method - Example
Comparison between NPV & IRR Methods
Accounting Return of Return (ARR ) Method ARR (also called Cost Benefit Method) is a ratio of the incremental net income to the required investment. It is calculated as follows: Incremental annual average after tax (accounting net income) / Net initial investment This method uses accounting income and not cash flows Advantage of the ARR is that it is easy to do and to understand The disadvantages of ARR are: Does not incorporate the time value of money Focuses on operating income instead of cash flow
ARR Method - Example
How do you Rank Projects? What if: NPV is higher for Project A but has lower IRR than Project B IRR of Project A is lower than threshold IRR but is of strategic importance Two projects have positive NPV and IRRs higher than hurdle rate? Project A has a life of 12 years while Project B has a life of 6 years Use concept of Profitability Index, PI also called Benefit-Cost Ratio is used to rank capital investment projects PI is calculated as PV of Cash Inflows / Initial Investment Rule of Evaluation Rule : If PI > 1, accept ; If PI < 1, Reject Also useful method when there is a capital constraints
Ranking Projects - Example The data for 3 projects are as under: Question : If the Company had $ 175,000 to invest, which project or a combination thereof would be undertaken?
Risk Analysis Sensitivity Analysis Is a What-if Technique Evaluates how the NPV, IRR, Payback change with change in parameters such as discount rate, material costs, labor costs etc. Helps in planning for uncertainties Scenario Analysis Uses single point estimates based on probability of scenarios of best, worst or most likely Simulation Analysis Simulation analysis computes the various outcomes if several variables or assumptions change simultaneously. Monte Carlo Analysis Based on computational algorithms which rely on random sampling Uses computerized simulations to generate hundreds of possible outcomes
What should be the Hurdle Rate? Should be cost of capital At times, opportunity cost/return may be used Cost of capital is a function of: Capital structure and components Cost of each component of capital structure Riskiness of project Cost of Capital is fluid and would change over time Should you apply different hurdle rates for different type of projects? Could there be conflicts between various funding sources?
Issues to consider Discount Rates Companies typically use the weighted average cost of capital Could also use a desired long term rate of return Sometimes, opportunity cost Project life Key consideration to evaluate cash flows Intermittent maintenance capex should be considered Don t ignore salvage value at end of useful life Initial Investment Consider all costs : equipment cost, shipping, commissioning If considering replacement, consider post tax salvage value of old machine Annual cash flows Adjusts for non cash charges, increases in working capital, tax All methods consider at of year cash flow for evaluation Ignore any intermediate funding/cash shortfalls Nominal or real cash flows?
Qualitative Considerations Following qualitative factors could influence capital investment decisions Lack of enough information to make capital investment decisions Firm may have self imposed capital rationing limits Loan provisions may limit borrowing and hence capital availability for projects Decision makers may be risk averse Managers could have conflicts between taking new projects which might affect their division performance in the near term Lack of sufficient qualified personnel to implement the project
Conflicts between Company and Shareholders
2. Lease V/s purchase
Key Aspects of a Lease Low upfront cost and regular annual cost Ownership rests with lessor during the lease period Post lease period, asset could be transferred to Lessee for a fee Depreciation benefit claimed by Lessor Off balance sheet item for Lessee Normally, tax deductible expense for Lessee Terms of lease would be a function of type of equipment Typical terms include: Tenor which could be 5+ years Upfront fee which could include up to paying one instalment Lease interest is typically costlier than bank loans End of term transfer fee is nominal, could be linked to book value
Key Aspects of a Purchase Ownership rests with the Company Upfront cash outflow to the Company for the equipment On balance sheet item for the Company Depreciation benefit available to the Company Depreciation and interest on loan taken to purchase are tax deductible expense for the Company
Considerations for Lease v/s Purchase Decision Calculate Net Advantage of Leasing which compares Present value of cost of leasing the asset, and Present value of cost of owning the asset If NAL is positive, then lease the asset NAL is equal to Installed Cost of Asset Less : Present value of after tax lease payments (discount rate = borrowing cost) Less : Present value of depreciation tax shield (discount rate = borrowing cost) Add : Present value of after tax maintenance cost incurred, if owned (discount rate = borrowing cost) Less : Present value of the after-tax salvage value (discount rate = target rate of return)
Lease v/s Buy An Example Option to Lease or Purchase of USD 75 mn of new equipment Lease terms Tenor : 5 years Lease rent : USD 280 per thousand After 5 years, transfer to Company at nominal salvage value Purchase Depreciation rate : 20% Borrowing rate : 8% Target rate of return of the company : 10% Equipment would require annual maintenance cost of USD 2.0 million Tax rate : 30% Salvage Value = USD 5 million
Lease v/s Buy An Example