ACCA F9 part D investment appraisal.ppt

PartDInvestmentAppraisal DCFmethodsandvaluationcriteria CapitalInvestmentAppraisal Interestisthepricethattheborrowerpaystothelenderforthetemporaryuseofmoney thereforemoneyhasatimevalue i e theeconomicvalueofagivenamountofmoneydependsonwhenthemoneywasreceivedordisbursed Thefinancialmarketandthesupplyofsavingsandthedemandforloansintheeconomydetermineinterestratelevel Interest TheinterestrateistheopportunitycostofwhatthemoneyinvestedcouldearninthebestalternativeofthesameriskclassSince 100todaydoesNOTequal 100inoneyear weneedamethodtocomparemoneyacrossdifferenttimeperiods SimpleInterest I Pi iswhenonlytheoriginalamountinvestedearnsinterest CompoundInterestiswhenthesubsequentlyaccruedinterestearnsinteresttoo notjusttheoriginalamount Compoundingcomputesthefuturevalueofcashflowsfromthepast Futurevalueofalumpsum Compound interestfactor Discountingcomputesthepresentvalueoffuturecashflows Presentvalueofalumpsum Discountfactor anannuityisseriesofequal fixedcashpaymenttobepaidorreceivedataregularperiods Perpetuities TheDeterminantsofInterestRates Theinterestrateonaparticularsecurityisdeterminedbyfourmainfactors 1 Currentinvestmentopportunitiesandconsumers preferences short termriskfreeinterestrateorrealinterestrate 2 Investortimepreferencesandfutureinvestmentopportunities thetermstructureofinterestrates 3 Expectedinflation nominalversusrealinterestrate 4 Risklevelofthesecurity premiumforrisk 1 Short term risk free realinterestrate Isthepriceofmoneyatwhichthedemandforinvestmentisequaltothesupplyofcapital Thisistheequilibriummarketrate supply demand Loanablefunds theory frameworkforinterestratedetermination LoanableFunds LoanableFunds Thesupplyofcapitalisupwardsloping Saversarewillingtosavemoreasinterestratesincrease Greatersupplyoffundsavailableathigherinterestrates Thedemandforinvestmentisdownwardsloping Atlowerinterestrates investorscanaffordtoborrowandmakemoreprofits wherethesupplyslopeanddemandslopemeet isthepointwherethedemandforinvestmentisequaltothesupplyofcapital Thisistheequilibriummarketrate 2 Thetermstructureofinterestrates Thetermstructuredefinestherelationshipbetweentheannualizedinterestratesonsecuritieswithdifferentmaturities 1 kn 1 r1 1 r2 1 rn Wherekn currentinterestrateonaloanwithnyearstomaturity n Onaverage long terminterestratesare short terminterestrates Saverssupplylessfundsforlong termloansbecausetheyprefershort termloanssotheycancashinsooner i E Liquiditypreference Thusahigherinterestrateisneededtogetsaverstolendforlongerterms Borrowershaveagreaterdemandtoborrowlong termtoreduceuncertaintyintheirfinancing Saverssupplymoremoneyforshort termsandborrowersdemandmorefundsforlong terms Interestrateissetattheequilibriumpointwherethesupplyoffundsequalsthedemandoffunds Longer termbondsaremoresensitivetochangesinmarketinterestratesthanshorter termbonds PVconcept Thelongeritistomaturity thelowerthepresentvalue Recallweusethemarketinterestratetocalculatethepresentvalue thusithasadirecteffectonthepriceofthebond Classexample1 Interestrateis10 forthisyearand20 fornextyear Ifyouinvest 1today a whatisyourrateofreturnat2years b Whatistheannualinterestrate Timeline yr0yr1r1 10 yr2r2 20 llltoday 1 10 1 32 a 1 kn 1 r1 1 r2 1 k2 1 0 10 1 0 20 b Recallr 1 i 1 n 2 n a 1 kn 1 r1 1 r2 1 k2 1 0 10 1 0 20 1 32b Recallr 1 i 1 14 89 Proof 1x1 1489 1 1489attheendofyear1 1 1489x1 1489 1 32attheendofyear2 Whydoweannualizeinterestrates n 2 n ClassExample2 Theinterestrateona1 yearbondis6 andona2 yearbondis10 Assumingyouareindifferentbetweeninvestinginthe2 yearbondorinvestinginthe1 yearbondandreinvestingattheendofoneyearforanotheryear Whatistheexpectedinterestrateforyear2 1stWhatisthequestionasking Indifferentmeansyouwouldreceivethesamereturn Sowewanttoknowwhatisr2 Formula 1 kn 1 r1 1 r2 n Sentence Ifinterestrateis14 15 inyear2 wewouldbeindifferenttoinvestinthe1 yearor2 yearbond asthereturnattheendofyear2 1 21 isthesame 3 Expectedinflation Istherateofchangeinpricesofarepresentative basket ofcommodities acommonyardstickisthechangeinConsumerPriceIndex Nominalinterestrate k iscomposedofrealrisk freeinterestrate r plusaninflationcomponent i k r i 4 Risk Theinterestratethatafirmmustcommittoontheirdebtincreaseswiththeriskofdefaultasperceivedbyinvestors Riskofdefaulthas2effects 1 Inordertoreceiveagivenexpectedreturn thenominalinterestratemustbe theexpectedreturntoadjustforthepossibilityofnon payment 2 Sinceinvestorsarerisk averse theywilldemandariskpremiumonriskysecurities Classexample4 Afirmborrows 1 000foroneyearandthelenderrequiresa9 return Thereisa5 chanceofdefault Whatinterestratewillthelenderrequire 1stWhatistheinterestrequired 1 000 x9 Interestrequired Probability interest 0 95 I 05 0 90 Outof100loans 95willearn 94 74and5willearn 0 Thusaveraging 90Proof 95x 94 74 100 90 2ndTogetinterestof 94 74on 1 000originalinvestment Interestrate interest originalinvestment 94 74 1 000 9 474 BasicPrinciplesRequiredandTested SimpleVcompoundinterestNominalVeffectiveinterestrates D 05CompoundinganddiscountingPV FVUseofannuitiesandperpetuitiesImportanceoftimevalueofmoneyRoleofcostofcapitalinappraisalinvestment Stated EffectiveInterestRateforVaryingCompoundIntervals Interestratesare byconvention quotedinannualterms However thecompoundingintervalcanvary Byconvention anaccountthatpays10 stated interestbutiscompoundedquarterlyistreatedasfollows 10 annuallyis10 4 2 5 perquarterandcashintheaccountiscompoundedquarterly 1after1quarter 1 1 025 1 0250 1after2quarters 1 1 025 2 1 0506 1after3quarters 1 1 025 3 1 0769 1after1year 1 1 025 4 1 1038Notethatafteroneyearthebalanceis 1 1038 foraneffectivereturnof10 38 morethanthestated10 rate ShortercompoundingintervalsraisetheeffectiveannualinterestrateEXAMPLEYoucanearnaneffectiveannualinterestrateof7 Whatisthepresentvalueofthree 10paymentstobereceivedin3 6 and9months Tocalculatethepresentvalue itisnecessarytodeterminetheeffectiveinterestrateforathree monthinterval quarter Todothis defineqastheeffectivequarterlyinterestrate Inotherwords ifyouearnatrateqforfourquarters youwouldearn7 fortheyear 1 q 4 1 07q 1 07 1 4 1q 0 0171 or1 71 Thus earninganeffectivequarterlyinterestrateof1 71 isequivalenttoearninganeffectiveannualinterestrateof7 Then PV 10 1 0171 10 1 0171 2 10 1 0171 3 9 83 9 67 9 50 29 00Youcanthereforealwaysconvertfromourannualopportunitycostoffundstoanyperiodiceffectiveinterestrate back Annuityandperpetuity Anannuityisafixedcashpaymentreceivedatregularintervalsforsomelimitedlengthoftime ordinaryannuities isdefinedasanannuitypaidorreceivedattheendoftheinterestcompoundingperiod upposer 5 then 1 1 r 1 1 r 2 1 1 r 3 0 9524 0 9070 0 8638 2 7232Notecarefullythenotationanr Inthisexample thenotationisa35 whichtranslatestothreeyearsat5 Example Onyourson s18thbirthday youhavesaved 100 000forhiseducation Interestrateis10 andyoursonplanstobecomeaspecialistinthefieldofmedicinesoheisexpectedtobe30yearsoldwhenheisdone a Whatfixedamountofmoneycanbetakenoutattheendofeachyearforhiseducation b Howmuchdidtheparentshavetosaveattheendofeachyearfromtheirson sbirthinordertoaccumulate 100 000ontheirson s18thbirthday Interestrateisstill10 Soln a 1stDeterminewhattypeofannuity Paymentmadeatendsoordinaryannuity Whatdoweneedtodetermine Thepayments Whatinformationdoweknow PV 100 000 r 10 n 12years 30 18 Formulamethod 100 000 A 1 1 0 1 12 0 1 A 100 000 6 8137 14 676 31Sentence Thesoncantakeout 14 676 33attheendofeachyear b Whatarewetryingtodetermine Atendsoordinaryannuityandwewanttodeterminethetime n Inthiscase the 100 000istheFV Formulamethod 100 000 A 1 0 1 18 1 0 1 A 100 000 45 5992 2 193 02Sentence Theparentswouldhaveinvested 2 193 02attheendofeachyear back Thecostofcapitalistheminimumafter taxrateofreturnthefirmmustearnonnewinvestment initsownriskclass tojustcompensatethefirm sinvestorswiththeirrequiredratesofreturn Thecostofcapitalisanopportunitycost back Investment Investmentisanyexpenditureintheexpectationoffuturebenefits capitalexpenditureIncurtoacquireandimproveearningcapacityofanon currentasset revenueexpenditureForthepurposeofthetradeofthebusinessortomaintaintheexistingearningcapacityofthenon currentassets Thecapitalbudgetingdecisionprocess TheprocessofIdentifyingAnalysingSelectinginvestmentprojectsThecapitalbudgetingentailsdecisionsonhowtoallocatefundsacrosspotentialnewcapitalassets ex newproducts plants equipment Theinvestmentdecision makingprocess OriginationofproposalsProjectscreeningAnalysisandacceptanceMonitoringandreview Relevantcashflowstoevaluateincapitalbudgeting FourRuleswhenestimatingprojectcashflows 1 Actualcashflows notaccountingincome Accountingincomeincludesnon cashexpenses ex amortization andincludesallocatedoverheadcost ignoreifnotincremental Shareholdersonlyconcernedwithactualcashflowbecausethatiswhatisusedtopaydividendsandinvestments 2 Incrementalcashflows Ignoresunkcosts anyexpendituresmadePRIORtocapitalbudgetingdecisionandcannotbereclaimed Includeopportunitycosts chargeresourcesthatsitidleand orhavealternativeusestothenewproject lostopportunitycost 3 Nominalcashflows Inflationmustbeincorporatedinboththeestimateoffuturecashflowsgeneratedfromtheprojectandthediscountrateusedtodeterminecostofcapitalforpropercomparison Thus usenominalratesandmarketyieldsthatreflectexpectedinflation 4 After taxcashflows Shareholderscanonlybenefitfromafter taxcashflows dividends capitalgains Differentprojectshavedifferenttaxexposures ex taxcredits Gov tgrants toencouragecertaininvestments Donotincludefinancialchargesassociatedwithfinancingofaprojectastheyareincorporatedinthediscountrate avoiddoublecounting Capitalbudgetingevaluationcriteria 1 NetPresentValue NPV NPVisadiscountcashflowmethod Itmeetstwocriticalrequirementsforanycapitalbudgetingrule 1 Accountsforthetimevalueofmoney2 Considersallrelevantcashflows NPVisthesumofalldiscountedcashflowsgeneratedbyaproject Itrepresentstheeconomicgainfromtheprojectandthusitmeasurestheincreaseinvaluetothefirm AcceptedpositiveNPVproject Theobjectiveofafinancialexecutiveistomaximizeshareholderwealth shareprice Giventhisobjective thefinancialexecutiveshouldchoosenewinvestmentsthatincreaseshareprice ProjectswithpositiveNPVstranslateintoanincreaseinfirm svalueequaltotheamountoftheNPV Thus NPVrule acceptpositiveNPVprojects subjecttocapitalrationingconstraints isthecorrectcapitalbudgetingcriterionsinceitcoincideswiththeobjectiveofmaximizingshareholderwealth Classexample Anewprojectwillpayarisk free perpetualaftertaxcashflowof 500 yrandthecurrentcostofthisprojectis 9 500 Iffirm svalueis 100 000andrisk freerateis5 isthisagoodproject Recallperpetualformula PV return interest 500 0 05 10 000 ThustheNPV 9 500 cost 10 000 PVoffuturecashflow 500 Note asaDCFmethod itistheNPVatsomelevelofdiscountrate marketinterestrate costofcapital etc 2 TheInternalRateofReturn IRR isanotherdiscountcashflowmethodthatcalculatesthebreak evenrateofreturnontheprojectsuchthattheNPV 0 Inotherwords bydefinition theIRRistherateofdiscountthatwhenappliedtothecashflowsofaninvestment willyieldanetPVofZERO TheIRRcriterionistoacceptaprojectiftheIRR theprojectedriskadjusteddiscountrate k IRRistheinterestrateatwhichNPVequalszero Inequationform IRRistherateatwhichwhereCisthecostoftheprojecttisthetimeframekistheinterestrate IRR UsuallyNPVandIRRcriteriaareconsistent Advantage easytounderstandapercentagereturn TwocomplicationsthatoccurwhenusingIRRare 1 MultipleIRRs whichonedoyouuse NeitherEx 2IRRs 15 50 bothsolveequation NPV 0 k 13 both kbutNPV 0using13 thusprojectisrejectedsoIRRrulefailed Thisoccurswhenthereisachangeindirectionoffuturecashflows netloss netincome netloss etc 2 CrossingNPVprofiles 2mutuallyexclusiveprojects chooseonewithhighestIRRbutNPVhigherwithprojectwithlowerIRR IRRmisleading OccurswhenthePVprofilesof2projectscrossoveratsomeratebeyondortotherightofthek RelianceontheIRRapproachimpliesthatfundsreleasedfromanyprojectcanbereinvestedatthatparticularproject sIRRTheNPVmethod impliesthatflowsreleasedfromanyprojectarereinvestedatthediscountratethatwasusedincalculatingitsNPV Theconflictsmayoccurbecauseofadifferenceinscalebetweenprojects astheNPVasanabsolutemeasureofinvestmentworthvarieswiththesizeoftheinvestmentwhereastheIRRasarelativemeasureremainsunaffected 3 Thepaybackperiod Thepaybackperiod PBP measuresthelengthoftimethatisrequiredforexpectedafter taxcashinflowstorecovertheinitialcostoftheproject Ex ProjectAgenerates 2 000 yrfor6yrsandthen 500 yrforthenext4years ProjectBgenerates 1 000 yrfor5yrs andthen 6 000 yrforthenext5yrs Initialcostofeachprojectis 10 000 Whichprojectwillyoupickifthepaybackperiodis5yrs Payback Cost 10 000therefore determinewheneachprojectmakesthe 10 000by ProjectA 2 000 2 000 2 000 2 000 2 000 10 000Thus5years ProjectB 1 000 x5years 6 000 11 000 Reach10 000between5and6thyear ThuschooseProjectAaswillreach 10 000sooner Disadvantages doesnotconsiderthetimevalueofmoney donotdiscountcashflows nopresentvalues ignoresallcashflowsbeyondthepaybackperiod nostandardtodeterminehowmanyyearsisacceptableforpaybackperiod 1 5 10years Advantages easytounderstand howlongbeforetheprojectisintheblack Theprofitabilityindex PI Theprofitabilityindex PI orbenefit costratioisthetotalpresentvalueoffuturecashflowsdividedbytheinitialinvestmentintheproject GPV cost ProjectisacceptableifthePI 1 rejectedifPI 1 PIwillaccept rejectthesameprojectsasNPVrule Disadvantage providesnohelpinselectingprojectsundercapitalrationingconditionsAdvantages PIruleisintuitive PIisthedollar to dollarreturnyouobtainonaproject CapitalRationing Generalmethodusedtoselectprojectswhenthereisaconstraintontheamountofcapitalthefirmcanspendonnewprojects CapitalrationingexistswhenthefirmhasgeneratedmorepositiveNPVprojectsthanitcanadoptduetoashortageoffunds Undercapitalrationing howshouldyouchoosethebestprojects Firsttrytoselltheideaorformajointventure Ifcannot usethePImethodtorankprojects godownlistuntilyouexhaustyourinvestablefunds Problem stillhavefundsleftbutnextproject sinitialinvestmentexceedstotalbudget NotutilizingfullinvestmentbudgetSolution Usebruteforcemethoduptocapitalspendingceiling acceptingthebasketofprojectsthatyieldsthehighestcombinedNPV Classexample Fourpotentialprojects Capitalbudgetis 200 ProjectInitial Invest GPVNPVPIA 6090301 50B110145351 32C95115201 21D253051 20PImethod noruletodeterminewheretogonext BruteForcemethod Listallcombinations packages Calculaterequiredinitialinvestment ifexceedsbudget throwout PickthepackagewiththehighestNPVs Packages A 60 30 B 110 35 C 95 20 D 25 5 AB 170 65 AC 155 50 AD 85 35 BD 135 40 CD 120 25 ABD 195 70 ACD 180 55NotepackagesBC ABC BCD ABCDcosts 200thusthrowout Thereturnoncapitalemployed ThepilotpaperstatestheROCEshouldbebasedontheaverageinvestmentPage189 Advantages QuickandsimplePercentagereturn easytounderstandLooksattheentireprojectlifeDisadvantages Basedonaccountingprofits notcashflowsRelativemeasureTakenoaccountoftime soIgnoretimevalueofthemoney DCFmethod ThecostofcapitalAfirm scostofcapitalisthecostofraisingadditionalinvestmentcapital intermsofrequiredpaymentstoinvestments Twoviewpoints fromtheviewpointofthefinancingfirmsthecostofcapitalisthecostintermsofrequiredpaymentstoinvestorsofraisingadditionalinvestmentcapital Thatis Managementofthefirmsetthecostofcapitaltoinducetheinvestorstoinvestinthefirm fromtheviewpointoftheinvestorsthecostofcapitalisanopportunitycost Thatisinvestorsdeterminewhattheycouldearniftheydidnotinvestinthefirmanddemandatleastthesamereturnfromthefirmthattheycangetelsewhere Thecostofcapitalistherequiredreturnonadollarcontributedtoday thus itreflectscurrentmarketcostsandvalues Thecostofcapitalistheafter taxcost intermsofrequiredpaymentstoinvestors ofraisingnewfunds thatthecostofcapitalisanappropriatehurdleratefornewcapitalbudgetingprojects SummaryThecostofcapitalistheminimumafter taxrateofreturnthefirmmustearnonnewinvestment initsownriskclass tojustcompensatethefirm sinvestorswiththeirrequiredratesofreturn Thecostofcapitalisanopportunitycost ProjectAppraisalAllowingforInflationandTaxation Therealrateofreturn isthereturninconstantpriceleveltermIninflatingenvironment usethemoneyrateofreturn nominalrateofreturn Ex Invest 1000foroneyear requiredrateofreturnis20 theinflationisexpectedtobe10 Thenafteroneyear theinitialinvestmentmustincreaseto 1200 intoday svalueterm equalsto 1091 1200 1 10 sotherealrateofreturnis9 1 we vegot 1 moneyrate 1 realrate 1 inflationrate 1 moneyrate 1 realrate 1 inflationrate EqualstoMoneyrate realrate inflationrate realrate inflationrate Whichrateisusedforcashflows Therulesasfollows Thecashflowsexpressedintermsoftheactualnumberofdollarsonfuturedates usenominalrate Thecashflowsexpressedintermsofthevalueofdollarsattime0 inconstantpricelevelterms userealrate CapitalAllowances Whatarecapitalallowances Areusedtoreducetaxableprofits resultsinthereductionoftaxpayment soitshouldbetreatedasacashsavingwhenaccepttheproject Depreciationinaccounting allowance WDA intaxationWhentheassetissoldSaleprice reducingbalance taxableprofit balancingcharge Saleprice reducingbalance taxallowableloss balancingallowance Howdocapitalallowancesaffectcashflows Capitalallowancesreducetaxpayment consideredascashflowin DoNOTEthat CapitalallowanceisnotacashflowinNPVcalculation itisthetaxbenefitofcapitalallowanceincludedinNPVcalculation Costsavingswillarisetaxpayment WhentaxationisignoredinDCFcalculations thediscountrateusePRE taxrateofreturnWhentaxationisincludedin useaPOST taxrequiredrateofrate ProjectAppraisalAllowingforRisk RiskVSuncertainty d 04 TXp228SystematicriskVSunsystematicrisk Interestratesetbythecentralbankvsrateofreturnofeachstock Methodsofdealingwithdecision makingunderriskandun