Financial Management Investment Appraisal
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Transcript of Financial Management Investment Appraisal
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ACCA 2.4Financial Management & Control
Lecture 10Appraisal of Investments
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What is Finance?
• A discipline mixing Accounting & Economics
• Considers – Theoretical Context & Processes of the
ways the “Economic Entity” raises funds from outside the entity
– The way it should or does apply these funds
– To create “Value” for the providers of funds
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What Managers Should Be Doing• Invest in projects that yield a return greater
than the minimum acceptable rate.– The rate should be higher for riskier projects and
reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
– Returns on projects should be measured based on cash flows generated and the timing of these cash flows
– they should also consider both positive and negative side effects of these projects.
• Choose a financing mix that minimizes the required rate and matches the assets being financed.
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What Managers Should Be Doing
• If there are not enough investments that earn the hurdle rate, return the cash to shareholders.– The form of returns - dividends and share
buybacks - will depend upon the shareholders’ characteristics.
• Objective: – Maximize the Value of the
Firm
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Investment Appraisal
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The Manager’s Duty• Invest in projects that yield a return greater
than the minimum acceptable rate.– Returns on projects should be measured based on
cash flows generated and the timing of these cash flows
– The minimum acceptable rate should be The minimum acceptable rate should be higher for higher for riskier projects riskier projects and reflect the and reflect the financing mix financing mix used - used - owners’ funds (equity) or borrowed money (debt)owners’ funds (equity) or borrowed money (debt)
– they should also consider both they should also consider both positive and positive and negative side effects negative side effects of these projectsof these projects
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Measuring the Project Cash Flow• Cash Flows on Projects Are
– OUT• Purchase of Assets
– Fixed Assets, Working Capital, Intangible Assets, • Operating Costs, Taxes
– IN• Sales of Assets
– Fixed Assets, Working Capital, Intangible Assets• Operating Income
• Note Financing Costs are excluded from this cash flow – this would be double counting
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Question The Frank Assuming Manufacturing Company is considering the purchase of a new machine for £200,000 as detailed below:
The machine is scheduled to last for 6 years and will be depreciated straight line over the period, with a scrap value of £50,000;
Capital allowances are available on this machine at 10% per annum on a straight-line basis, and the effective corporation tax rate is 35%. No further capital allowances are available if the machine is sold. The present 10% rate of capital allowance continues to apply in the year the machine is sold. Note that corporation tax is payable in the current year;
As it is expected to remove a production bottleneck, production will increase from 40,000 units to 50,000 units a year initially, and then to 56,000 units for the last three years;
The additional units will reduce the sales price from £3.60 each to £3.20 each; The machine will generate efficiency cost savings of £22,500 for each of the next 2
years and £30,000 thereafter until year 6; The company's cost of capital is 10%; Round up your figures to the nearest pound.
Further information – Present Values @ 10% Year 1 = 0.9091 Year 4 = 0.6830 Year 2 = 0.8264 Year 5 = 0.6209 Year 3 = 0.7513 Year 6 = 0.5645 a). Calculate the Payback period, Net Present Value, Accounting Rate of Return. Should the machine be bought?
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Measuring the Cash Flow
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The Cash Flow• The cash flow occurs during time periods• The initial outlay occurs in year zero• Depreciation is NOT a cash flow
– It is an accounting convention which attempts to spread the cost of buying an asset over the time periods during which the asset will be used
– This called the MATCHING PRINCIPLE – one of the fundamental accounting principles
• Depreciation may be used for calculating the Profit for the purposes of tax computation
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Calculate the Cash Flow
Question 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340
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Time Value of Money
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Consider the Cash Flow• Consider the cash flow timing
• Is £1 today worth more than £1 next year?• We must find some way of making the cash
flows in each year equivalent to each other
Question 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340
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Future Value
The Value of a Lump Sum or Stream of Cash Payments at a Future Point in Time
FVn = PV x (1+r)n
• Future Value depends on:
– Interest Rate– Number of Periods – Compounding Interval
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Future Value of £200 (4 Years, 7% Interest )
What if the Interest Rate Goes Up to 8% ?
0 1 2 3 4
PV = £200
End of Year
FV1 = £214
FV2 = £228.98
FV3 = £245
FV4 = £262.16
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Future Value of £200 (4 Years, 8% Interest )
0 1 2 3 4
PV = £200
End of Year
FV1 = £216
FV2 = £233.28
FV3 = £251.94
FV4 = £272.10
Compounding – The Process of Earning Interest in Each Successive Year
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Periods
0%Futu
re V
a lue
of O
n e P
ound
(£)
1.000 2 4 6 8 10 12 14 16 18 20 22 24
10.00
15.00
20.00
25.00
30.00
5.00
10%
5%
15%
20%
The Power Of Compound Interest
40.00
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Present Value
Today's Value of a Lump Sum or Stream of Cash Payments Received at a Future Point in Time
nn rPVFV 1
nn
rFV
PV)1(
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Present Value of £200 (4 Years, 7% Interest )
What if the Interest Rate Goes Up to 8% ?
0 1 2 3 4
Discounting
PV = £200
FV1 = £214 FV2 = £228.98 FV3 = £245 FV4 = £262.16
End of Year
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Present Value of £200 (4 Years, 8% Interest )
0 1 2 3 4
Discounting
PV = £200
FV1 = £216 FV2 = £233.28 FV3 = £252 FV4 = £272.10
End of Year
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The Power Of High Discount Rates
Periods
Pres
ent V
alu e
of O
ne P
o und
(£)
0 2 4 6 8 10 12 14 16 18 20 22 24
0.5
0.75
1.00
0.25 10%
5%
15%20%
0%
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Present Value Summary
• Much Of Finance Involves Finding Future And (Especially) Present Values
• Central To All Financial Valuation Techniques
• Techniques Used By Investors & Firms Alike
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Discounting the cash flow: Question 6• Cost of Capital is 10%
Question 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340Discount Factor 0.909 0.826 0.751 0.683 0.621 0.564PV of Cash Flow 200.230 28.523 25.930 27.235 33.017 30.015 55.510NPV 0.230
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Other Methods of Investment Appraisal• Payback period• How long is it before we get our money
backQuestion 6Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340Discount Factor 0.909 0.826 0.751 0.683 0.621 0.564PV of Cash Flow 200.230 28.523 25.930 27.235 33.017 30.015 55.510NPV 0.230Payback -270.000 -238.625 -207.250 -171.000 -122.660 -74.320 24.020Payback 5 Years 9 Months
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Payback Period Critique
• Measures how long funds are at risk• Simple to calculate• BUT• Does not take into account cash flows
after the payback
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Other Methods of Investment Appraisal• Accounting Rate of Return (ARR)Question 6
Year 0.000 1.000 2.000 3.000 4.000 5.000 6.000Cost -200.000 50.000Lower sales price -16.000 -16.000 -16.000 -16.000 -16.000 -16.000Additional Contrib 31.000 31.000 31.000 49.600 49.600 49.600Efficiency 22.500 22.500 30.000 30.000 30.000 30.000Tax Allowances 20.000 20.000 20.000 20.000 20.000 20.000Tax 6.125 6.125 8.750 15.260 15.260 15.260Cash Flow 31.375 31.375 36.250 48.340 48.340 98.340Discount Factor 0.909 0.826 0.751 0.683 0.621 0.564PV of Cash Flow 200.230 28.523 25.930 27.235 33.017 30.015 55.510NPV 0.230Payback -270.000 -238.625 -207.250 -171.000 -122.660 -74.320 24.020Payback 5 Years 9 MonthsCash Flow 31.375 31.375 36.250 48.340 48.340 48.340Depreciation 25.000 25.000 25.000 25.000 25.000 25.000Profit 6.375 6.375 11.250 23.340 23.340 23.340Average Profit 15.670ARR Initial 8%ARR Average 13%
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Accounting Rate of Return Critique
• Does not take account of timing of cash flows
• Spreads costs of assets over asset life• Reality is that cash flows out when
asset is purchased– Profit is a Concept– Cash is a Reality
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Other methods
• Internal Rate of Return– Similar to Net Present Value
• Involves calculating which rate of return will make Net Present Value = zero and comparing this with required rate of return
• Inferior to NPV– More complex to calculate– Can give multiple rates if large negative
cash flows at end of project
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The Manager’s Duty• Invest in projects that yield a return greater
than the minimum acceptable rate.– Returns on projects should be measured based on
cash flows generated and the timing of these cash flows
– The minimum acceptable rate should be higher for riskier projects and reflect the financing mix used - owners’ funds (equity) or borrowed money (debt)
– they should also consider both positive and negative side effects of these projects