principles of capital investment (3)

8/2/2019 Principles of Capital Investment (3)

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Principles of Capital

Investment


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RoadMapIntroductionAli Raza

Principles of Capital Investment Administrative Framework Investment Projects CashFlows

Project Evaluation TechniquesAnam Jawaid Average Rate of Return Payback Period Net Present Value

Internal Rate of Return Profitability Index

NPV, IRR ComparisonsShandana Nawaz NPV Verses IRR Compounding Rate Differences Scale of investment Capital Rationing

Capital BudgetingSara Syed

Capital Budgeting Inflation Biasness in Cashflows Aquisitions


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Introduction

When a firm makes capital investment,it incurs a current cash outlay for thebenefit to be realized in the future.

Principles of Capital Investment


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Introduction

Key Points

Most investment decisions involve outflows of cash, which result in

inflows of cash

Typically, an investment project involves a relatively large initial

investment (outflow of cash) at the beginning of the project

After the initial investment, a stream of cash inflows and outflows

spread over the project lifetime

Finally, provision may also have to be made for cash outflows

resulting from additional investments made over the project lifetime.

Large cash flows may also be required at the end of the project

lifetime

To evaluate the feasibility of investment projects investment.

Selecting which investment opportunities to pursue and which toavoid is a vital matter to businesses

Focus is usually placed on evaluating expected cash outflows and resulting cash inflows in order todetermine if project is profitable


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Administrative framework


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Investment Projects

Classification

New products or expansion of existing product

Replacement of equipment or building

Research and development

Exploration

Others

Types

Replacement projects - Most assets have finite lifespan will have to bereplaced when existing assets reach end of lifespan

Expansion projects - Company wants to expand its current level of operationsby either internal or external expansion

Independent projects - Acceptance of project does not influence otherprojects under consideration

Mutually exclusive projects - Implementation of one project results in rejectionof all other alternatives

Screening

Greater the capital outlay, greater the numbers of screen usually required.

Level and type of expenditure


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Compares initial cash investment to averageannual cash flow generated by project over itslifetime

Return per Unit Investment

Average Rate of Return

100*InvestmentInitial

yearperReturnReturnofRateAverage

100*InvestmentInitial

ReturnAverageReturnofRateAverage

Equal Return Every Year

Un-Equal Returns every year


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OOO

Sizwe Limited is choosing between two investments.Project A requires initial investment of R25 000;Project B requires amount of R100 000. The relevantannual cash inflows for each project are as follows:

Year Project A Project B1234

R5 000R10 000R15 000R20 000

R60 000R36 000R30 000R24 000

The AR for Project A can be determined as follows:

ARProject A =100xC

4/C

0

4

1t

t

=

100x00025

4/0000200015000100005

= 50%

Example


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Pros & Cons

Simple

Shows result inpercentage

Time value of moneyignored

Based on accountingincome instead ofcashflows

Benefits in last year arevalued the same as firstyear

Average Rate of Return


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Number of years required to recover our initial cashinvestment

cashflowannual

investmentinitialPeriodPayback

Payback Period

DPB calculates expected number of years requiredto recover initial investment by considering

discounted net cash flows Calculated based on cash flows that are

discounted at companys cost of capital

Discounted Payback Period

Normal Payback Period


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You are required to calculate the DPB for Project A if:Cost of Capital = 10%.Initial Investment = Rs. 25,000

YearCash flow

1234

5,00010,00015,00020,000

Accumulated cash flows after2years:5,000 + 10,000 = Rs.15,000

Only Rs10,000 of Year 3s cash flow required to recover initialinvestment.

yearsDBA

000,15

000,102AProject

= 2.67 years

Example (Payback Period)


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Pros & Cons

Simple

Tells breakevenpoint

No time value of

moneyFails to considercashflows afterpayback period

Doesnt measureprofitability

Payback Period


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You are required to calculate the DPB for Project A if:Cost of Capital = 10%.Initial Investment = Rs. 25,000

Year Project ACash flow Cash flow

discounted at10%

123

4

5,00010,00015,000

20,000

4,545.458,264.46

11,269.72

13,660.27Accumulated discounted cash flows after3years:

4,545.45 + 8,264.64 + 11,269.72 = Rs.24,079.63

Only Rs.920.37 of Year 4s discounted cash flow required to recoverinitial investment.

yearsDBA13,660.27

920.373AProject

= 3.07 years

Example (Discounted Payback Period)


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Difference between present value (PV) of allexpected net cash inflows and PV of allexpected net cash outflows calculated overexpected life of project

With NPV method: net cash flows arediscounted at cost of capital (i) to determine

their PV, and compared with initialinvestment

NPV = PV of expected cash flows initial investment

=

n

1t

0t

t C

i1

C

Net Present Value


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You are required to calculate the NPV for Project A if:

Cost of Capital = 10%Initial Investment = Rs. 25,000

Year Cashflow1234

5,00010,00015,00020,000

NPVProject A =

n

1

0C1

C

t

t

t

i

= 00025

1,10

00020

1,10

00015

1,10

00010

1,10

00054321

=00025

1,4641

00020

1,331

00015

1,21

00010

1,10

0005

= 4,545.46 + 8,264.46 + 11,269.72 + 13,660.27 25,000= Rs 12,739.91

Example


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Pros & Cons

Caters mutuallyexclusive projects

Compounded atrequired rate of returnas the discount rate

Scale of investment(expressed in

absolute terms)

Requires knowledgeof cost of capital

Sensitivity to discountrates

Net Present Value


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Discount rate that equates PV of expectednet cash inflows and PV of net cashoutflows

Net Cash Outflows = Net Cash Inflows

Discount rate that will result in

NPV = 0

0

0

CIRR1

C

0C-IRR1

C

n

1tt

t

n

1tt

t

Internal Rate of Return


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You are required to calculate the IRR for Project A.

Suppose that the cost of capital = 10%.

Based on the use of a financial calculator, the IRRis determined as follows:

Input Function25 000 Cf05 000 Cf110 000 Cf215 000 Cf3

20 000 Cf4

IRR = 27.27%

Example


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Pros & Cons

Simple

Percentage return is easy to

comprehend

Doesnt cater changing cashflows

Considers rate of earningsnot size of earnings

Only with independentprojects

Funds are compounded atIRR

Scale of investment(expressed as %age)

Multiple IRRs

Internal Rate of Return

d f d


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MIRR: Attempts to improve on IRR methodO Include more conservative view on

reinvestment rate earned on cash flowsgenerated during projects lifespan.

Also solves problem with multiple IRR

valuesO Cash stream converted into only cash inflow

and cash outflow value

PV Cash outflows = n

MIRR1

inflowscashofFV

Modified IRR

l


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Future values of the cash inflows for Project A

Year Project A

Cash flow Cash flowaccumulated

at 10%1234

R 5 000R10 000R15 000R20 000

R 6 655.00R12 100.00R16 500.00R20 000.00

R55 255.00

MIRR Project A is calculated by solving following equation:

PV Cash inflows = nMIRR1outflowscashofFV

-25 000 = 4MIRR125555

Solving equation yields MIRRProjectA = 21.93%.

Example

P fi bili I d


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Benefit-Cost Ratio

PV of net future cashflows over the initialcash outlay

investmentInitial

flowscashfutureofPVPI

Therefore, PI can be calculated by:

0

n

1t

t

t

C

i1

C

PI

Profitability Index

E l


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Calculate PI of Project A.Cost of capital = 10%

Year Project ACash flow Cash flow

discountedat 10%

1

234

R 5 000

R10 000R15 000R20 000

R 4,545.45

R 8,264.46R11,269.72R13,660.27R37,739.91

investmentInitial

flowscashfutureofPV

PI

25,000

37,739.91

Example

C i


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Comparisons

ROI Factor Value Comments

NPV

> 0 (Positive) Acceptable

0 (Zero) May or may not be acceptable

< 0 (Negative) Reject

IRR > Required Rate Acceptable< Required Rate Reject

PaybackPeriod

> AcceptablePeriod

Invest in a project with smallpayback period

< Acceptable

Period

Reject

ProfitabilityIndex

> 1 Or 1 Accept

< 1 Reject

NPV V IRR


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Caters mutuallyexclusive projects

Compounded at

required rate ofreturn as thediscount rate

Scale of investment(expressed inabsolute terms)

Only withindependent projects

Funds are

compounded at IRRScale of investment(expressed as %age)

Multiple IRRs

Net

PresentValue

InternalRateofRe

turn

NPV Versus IRR

NPV V IRR


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O Contradictory results in mutually exclusive projects

O Contradiction is due to the difference in the implicitcompounding of interest.

O Multiple IRRs are possible.

O How to overcome this issue?

Compounding Rate Differences

Multiple Rate of Return

NPV Versus IRR

C i l i i


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Capital Rationing

Rationing

Rationing is basically a process of controlled distribution ofresources

Capital Rationing

It occurs any time there is budget ceiling or constraint on theamount of funds that can be invested during specific period oftime.

What happens when the capital is rationed?

It can also be understood as taking example of a company thatis allowed to make capital expenditures up to specific budgetedceiling. Where division has no control.

Its purpose is to select the combination of investmentproposals offering greatest profitability.

You do not invest in all proposals increasing the NPV but youaccept the proposal within your budgeted amount.


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O Its objective is to select a combination ofinvestment proposals offering highest NPVkeeping in view the allocated budget.

O Cost of the certain investment projects may

spread over several years.

O Budget ceiling carries its cost too.

O Capital rationing results in an investment policythat is less than optimal

Selection Criteria

Problems

C i l B d i


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Capital budgeting(orinvestment appraisal) is theplanning processused to determine whether an

organization'slong terminvestmentssuchas new

machinery, replacement machinery, new plants,new products, and research development projectsareworth pursuing. It is budget for majorcapital, or

investment, expenditures.

Capital Budgeting

I fl i


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O In practice, an inflationary economy distorts capital budgetingdecisions

O As income grows with the inflation, an increasing portion istaxed with the result that real cash flows do not keep up withinflation

O Without inflation, depreciation charges represent the cost ofreplacing the investment.

O The presence of inflation results in lower real rates of returnand less incentives for companies to undertake capitalinvestments.

Inflation

Definition

Inflation is the increase in the general level of prices for allgoods and services in an economy.

Effects

Bi i C hfl


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O In estimating cash flows, it is important that theindividual company take anticipated inflation intoaccount.

O Future inflation does not affect depreciation

charges on existing assets.O The effect of anticipated inflation varies with cash

inflows and outflows.

O If a nominal required return is used, nominal cash

flows (inflation adjusted) should be employed.

Biasness in Cashflows

Analysing Acquisition


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O It is earning before interest, tax, depreciation and

amortization.O From the EBITDA estimates, we subtract three things:O Expected taxes to be paid

O Likely future capital expendituresO Expected net additions to working capital.

O In the case of an acquisition investment, the life of theproject is indefinite.

Analysing Acquisition

Measuring Free Cashflows

EBITDA

O Free cash flows are what remain after all necessaryexpenditures and they determine an acquisition value.

O In evaluating the prospective acquisition, the buyingcompany should estimate the future cash income that theacquisition is expected to add.

N C h P t A d


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O What would be the acquisition other than thecash???

O

Sometimes, the buyer assumes the liabilities ofthe company it acquires.

O If securities other than cash are used in theacquisition, they should be converted to theircash equivalent market values.

Non Cash Payments AndLiability Assumptions


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principles of capital investment (3)

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