Learning Outcome 1 - Ac 2 (Analytical Methods)

7/28/2019 Learning Outcome 1 - Ac 2 (Analytical Methods)

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LOC 1 AC 2 Capital Expenditure Evaluation For Long Term Plan

Capital expenditure situation is one in which the companys funds arecommitted to projects which will return the invested funds and profit

during future periods. The objective is to evaluate from alternatives theproject (investment) which will promote the profitability and long-range growth of the enterprise. These evaluation methods simply act asa guide and help communicate useful information to the decision-maker. The actual decision is based on many diverse factors whichcannot be incorporated into an overall formula or technique. In makingeconomic comparisons it is important to ensure that the variousalternatives are substantially equivalent, particularly with regard totheir technical specification and performance characteristics.

Traditional methods includes,(1) Payback, (2) Return on capital employed and (3) Discounted cashflow method.

(1) Payback To determine the number of years it takes to payback theoriginal investment from profits arising from the investment.Project can be considered on (a) An accept-reject basis dependingon the payback period, or (b) Project ranking, where the fastest

paying-back project is accepted from a number of mutuallyexclusive projects.

(2) Return on Capital Employed is a ratio that indicates theefficiency and profitability of a companys capital investments.Thus, it is a indicator of how well a company is utilizing capital togenerate revenue. The ROCE is done by taking profit beforeinterest and tax (EBIT) and dividing that by the difference betweentotal assets and current liabilities.

Formula:ROCE = EBIT / (Total assets Current Liabilities)

Or,ROCE = Operating Profit / Equity Shareholders Funds


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(3) Discount cash flow method which consists of :(a) Net Present Value (NPV)(b) Internal Rate of Return (IRR)

Net present value (NPV) is a standard method for the financialappraisal of long-term projects. Used forcapital budgeting, and widelythroughout economics, it measures the excess or shortfall of cash flows,in present value (PV) terms, once financing charges are met. Bydefinition, NPV = Present value of net cash flows. For its expression,see the formula section below.

Formula

Each cash inflow/outflow is discounted back to its PV. Then they aresummed. Therefore

Where

t- the time of the cash flow

n - the total time of the projectr- the discount rateCt - the net cash flow (the amount of cash) at time t.C0 - the capital outlay at the beginning of the investment time ( t= 0 )

The Discount Rate

The rate used to discount future cash flows to their present values is akey variable of this process. Most firms have a well defined policyregarding their capital structure, so the weighted average cost of capital(after tax) is used with all projects. Some people believe that it isappropriate to use higher discount rates to adjust for risk for riskier

projects. Another method is to use a variable discount rate with higher
http://en.wikipedia.org/wiki/Capital_budgetinghttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Weighted_average_cost_of_capitalhttp://en.wikipedia.org/wiki/Capital_budgetinghttp://en.wikipedia.org/wiki/Economicshttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Weighted_average_cost_of_capital


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rates applied to cash flows occurring further along the time span,(reflecting the yield curve premium for long-term debt).

Another approach to choosing the discount rate factor is to decide the

rate which the capital needed for the project could return if invested inan alternative venture. If, for example, the capital required for ProjectA can earn five percent elsewhere, use this discount rate in the NPVcalculation to allow a direct comparison to be made between Project Aand the alternative. Related to this concept is to use the firm'sReinvestment Rate. Reinvestment rate can be defined as the rate ofreturn for the firm's investments on average. When analyzing projectsin a capital constrained environment, it may be appropriate to use thereinvestment rate rather than the firm's weighted average cost of capital

as the discount factor. It reflects opportunity cost of investment, ratherthan the (typically) lower cost of capital.

NPV value obtained using variable discount rates (if they are known)with the years of the investment duration better reflects the realsituation than that calculated from a constant discount rate for the entireinvestment duration. Refer to the tutorial article written by SamuelBaker[1] for more detailed relationship between the NPV value and thediscount rate.

For some professional investors, their investment funds are committedto target a specified rate of return. In such cases, that rate of returnshould be selected as the discount rate for the NPV calculation. In thisway, a direct comparison can be made between the profitability of the

project and the desired rate of return.

To some extent, the selection of the discount rate is dependent on theuse to which it will be put. If the intent is simply to determine whethera project will add value to the company, using the firm's weightedaverage cost of capital may be appropriate. If trying to decide betweenalternative investments in order to maximize the value of the firm, thecorporate reinvestment rate would probably be a better choice.

Using variable rates over time, or discounting "guaranteed" cash flowsdifferent from "at risk" cash flows may be a superior methodology, but
http://en.wikipedia.org/wiki/Net_present_value#_note-slbaker%23_note-slbakerhttp://en.wikipedia.org/wiki/Net_present_value#_note-slbaker%23_note-slbaker


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is seldom used in practice. Using the discount rate to adjust for risk isoften difficult to do in practice (especially internationally), and is reallydifficult to do well. An alternative to using discount factor to adjust forrisk is to explicitly correct the cash flows for the risk elements, then

discount at the firm's rate.

What NPV Means

NPV is an indicator of how much value an investment or project addsto the value of the firm. With a particular project, if Ct is a positivevalue, the project is in the status of discounted cash inflow in the timeoft. IfCt is a negative value, the project is in the status of discountedcash outflow in the time of t. Appropriately risked projects with a

positive NPV be accepted. This does not necessarily mean that theyshould be undertaken since NPV at the cost of capital may not accountforopportunity cost, i.e. comparison with other available investments.In financial theory, if there is a choice between two mutually exclusivealternatives, the one yielding the higher NPV should be selected. Thefollowing sums up the NPVs in various situations.

If... It means... Then...

NPV> 0

the investmentwould add valueto the firm

the project may be accepted

NPV< 0

the investmentwould subtractvalue from thefirm

the project should be rejected

NPV= 0

the investmentwould neither gainnor lose value forthe firm

We should be indifferent in the decisionwhether to accept or reject the project. Thisproject adds no monetary value. Decisionshould be based on other criteria, e.g. strategic

positioning or other factors not explicitlyincluded in the calculation.
http://en.wikipedia.org/wiki/Opportunity_costhttp://en.wikipedia.org/wiki/Opportunity_cost


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However, NPV = 0 does not mean that a project is only expected tobreak even, in the sense of undiscounted profit or loss (earnings). It willshow net total positive cash flow and earnings over its life.

Example

X corporation must decide whether to introduce a new product line.The new product will have startup costs, operational costs, andincoming cash flows over six years. This project will have animmediate (t=0) cash outflow of $100,000 (which might includemachinery, and employee training costs). Other cash outflows for years1-6 are expected to be $5,000 per year. Cash inflows are expected to be$30,000 per year for years 1-6. All cash flows are after-tax, and there

are no cash flows expected after year 6. The required rate of return is10%. Thepresent value (PV) can be calculated for each year:

T=0 -$100,000 / 1.100 = -$100,000 PV.T=1 ($30,000 - $5,000) / 1.101 = $22,727 PV.T=2 ($30,000 - $5,000) / 1.102 = $20,661 PV.T=3 ($30,000 - $5,000) / 1.103 = $18,783 PV.T=4 ($30,000 - $5,000) / 1.104 = $17,075 PV.T=5 ($30,000 - $5,000) / 1.105 = $15,523 PV.

T=6 ($30,000 - $5,000) / 1.10

6

= $14,112 PV.

The sum of all these present values is the net present value, whichequals $8,881. Since the NPV is greater than zero, the corporationshould invest in the project.

The same example in an Excel formulae:

NPV(rate,net_inflow)+initial_investment PV(rate,year_number,yearly_net_inflow)
http://en.wikipedia.org/wiki/Required_rate_of_returnhttp://en.wikipedia.org/wiki/Present_valuehttp://en.wikipedia.org/wiki/Required_rate_of_returnhttp://en.wikipedia.org/wiki/Present_value


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http://en.wikipedia.org/wiki/Image:DiscreteCF.jpghttp://en.wikipedia.org/wiki/Image:PV_example.jpg


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More realistic problems would need to consider other factors, generallyincluding the calculation of taxes, uneven cash flows, and salvagevalues as well as the availability of alternate investment opportunities.

The internal rate of return (IRR) is a capital budgeting metric used byfirms to decide whether they should make investments. I t is anindicator of the efficiency of an investment (as opposed to NPV, whichindicates value or magnitude).

The IRR is the annualized effective compounded return rate which canbe earned on the invested capital, i.e. the yield on the investment.

A project is a good investment proposition if its IRR is greater than therate of return that could be earned by alternative investments (investingin other projects, buying bonds, even putting the money in a bank

account). Thus, the IRR should be compared to an alternative cost ofcapital including an appropriate risk premium.

Mathematically the IRR is defined as any discount rate that results in anet present value of zero of a series of cash flows.
http://en.wikipedia.org/wiki/Cash_flowshttp://en.wikipedia.org/w/index.php?title=Salvage_values&action=edithttp://en.wikipedia.org/w/index.php?title=Salvage_values&action=edithttp://en.wikipedia.org/wiki/Capital_budgetinghttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Yield_(finance)http://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Net_present_valuehttp://en.wikipedia.org/wiki/Image:CumCF.jpghttp://en.wikipedia.org/wiki/Cash_flowshttp://en.wikipedia.org/w/index.php?title=Salvage_values&action=edithttp://en.wikipedia.org/w/index.php?title=Salvage_values&action=edithttp://en.wikipedia.org/wiki/Capital_budgetinghttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Yield_(finance)http://en.wikipedia.org/wiki/Discount_ratehttp://en.wikipedia.org/wiki/Net_present_value


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In general, if the IRR is greater than the project's cost of capital, orhurdle rate, the project will add value for the company.

Method

To find the internal rate of return, find the IRR that satisfies thefollowing equation:

The IRR uses the NPV equation as its starting point:

Calculating the IRR is done through a trial-and-error process thatlooks for the Discount Rate that yields an NPV equal to zero. Thetrial-and-error calculation can by accomplished by using the IRRfunction in a spreadsheet program or with a programmable calculator.

The graph below was plotted for a wide range of rates until the IRRwas found that yields an NPV equal to zero (at the intercept with thex-axis). As in the example above, a project that has a discount rateless than the IRR will yield a positive NPV. The higher the discountrate the more the cash flows will be reduced, resulting in a lower

NPV of the project. The company will approve any project orinvestment where the IRR is higher than the cost of capital as the

NPV will be greater than zero.
http://en.wikipedia.org/wiki/Cost_of_capitalhttp://en.wikipedia.org/wiki/Hurdle_ratehttp://en.wikipedia.org/wiki/Value_(economics)http://en.wikipedia.org/wiki/Cost_of_capitalhttp://en.wikipedia.org/wiki/Hurdle_ratehttp://en.wikipedia.org/wiki/Value_(economics)


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The IRR is therefore the maximum allowable discount rate that wouldyield value considering the cost of capital and risk of the project. Forthis reason, the IRR is sometimes referred to as a break-even rate ofreturn. It is the rate at which the value of cash outflow equals the

value of cash inflow.

There are some special situations where the IRR concept can bemisinterpreted. This is usually the case when periods of negative cashflow affect the value of IRR without accurately reflecting theunderlying performance of the investment. Managers maymisinterpret the IRR as the annual equivalent return on a giveninvestment. This is not the case, as the IRR is the breakeven rate anddoes not provide an absolute view on the project return.

Problems with using IRR (Further Readings)

As an investment decision tool, the calculated IRR should not be usedto rate mutually exclusive projects, but only to decide whether a single

project is worth investing in. In cases where one project has a higherinitial investment than a second mutually exclusive project, the first

project may have a lower IRR (expected return), but a higher NPV(increase in shareholders' wealth) and should thus be accepted over the

second project (assuming no capital constraints).

IRR makes no assumptions about the reinvestment of the positive cashflow from a project. As a result, IRR should not be used to compare

projects of different duration and with a different overall pattern of cashflows. Modified Internal Rate of Return (MIRR) provides a betterindication of a project's efficiency in contributing to the firm'sdiscounted cash flow.

The IRR method should not be used in the usual manner for projectsthat start with an initial positive cash inflow (or in some projects withlarge negative cash flows at the end), for example where a customermakes a deposit before a specific machine is built, resulting in a single

positive cash flow followed by a series of negative cash flows (+ - - --). In this case the usual IRR decision rule needs to be reversed.
http://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Returnhttp://en.wikipedia.org/wiki/Investmenthttp://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Return


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If there are multiple sign changes in the series of cash flows, e.g. (- + -+ -), there may be multiple IRRs for a single project, so that the IRRdecision rule may be impossible to implement. Examples of this type of

project are strip mines and nuclear powerplants, where there is usually

a large cash outflow at the end of the project.

In general, the IRR can be calculated by solving a polynomial. Sturm'sTheorem can be used to determine if that polynomial has a unique realsolution. Importantly, the IRR equation cannot be solved analytically(i.e. in its general form) but only via iterations.

A critical shortcoming of the IRR method is that it is commonlymisunderstood to convey the actual annual profitability of an

investment. However, this is not the case because intermediate cashflows are almost never reinvested at the project's IRR; and, therefore,the actual rate of return (akin to the one that would have been yielded

by stocks or bank deposits) is almost certainly going to be lower.Accordingly, a measure called Modified Internal Rate of Return(MIRR) is used, which has an assumed reinvestment rate, usually equalto the project's cost of capital.

Despite a strong academic preference for NPV, surveys indicate that

executives prefer IRR over NPV. Apparently, managers find it easier tocompare investments of different sizes in terms of percentage rates ofreturn than by dollars of NPV. However, NPV remains the "moreaccurate" reflection of value to the business. IRR, as a measure ofinvestment efficiency may give better insights in capital constrainedsituations. However, when comparing mutually exclusive projects,

NPV is the appropriate measure.

In addition if the NPV of one project is higher than another and theother project has a higher IRR, then the cross over point method can beused to solve this dispute.

Cross Over Point > IRR = Accept project with higher NPV and if theCross Over Point < IRR = Accept project with higher IRR
http://en.wikipedia.org/wiki/Strip_minehttp://en.wikipedia.org/wiki/Nuclear_powerhttp://en.wikipedia.org/wiki/Sturm's_Theoremhttp://en.wikipedia.org/wiki/Sturm's_Theoremhttp://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Returnhttp://en.wikipedia.org/wiki/Strip_minehttp://en.wikipedia.org/wiki/Nuclear_powerhttp://en.wikipedia.org/wiki/Sturm's_Theoremhttp://en.wikipedia.org/wiki/Sturm's_Theoremhttp://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Return


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Question 1

Maju Indah Sdn Bhd has 2 construction projects planned for investment.However, due to limitation on capital, only 1 project will be selected andimplemented. The initial investment and payback amount for the projects

are as follows:

Year Project 1 (million-RM) Project 2 (million-RM)

Year 0 -100 -100

Year 1 +30 +60

Year 2 +40 +40

Year 3 +50 +30

Year 4 +60 +20

(a) Determine the payback period for the projects.(b) Determine the total net profit, using the net present values (based on 14%interest rate), for the projects.(c) Analysis the Internal Rate of Return for the projects.(d) Comment to your management for which construction project should bechosen based on the outcomes in (a), (b) and (c).

Question 2

Houseman Sdn Bhd has 2 alternatives to invest their construction project.One is to purchase a machine X, with smaller capacity, and replace it after 2

years time. Another option is purchase higher capacity; machine Y, to beused for all project life. The cost of investment and payback amounts areshown as follows :

Year Machine X (RM) Machine Y (RM)

Year 0 -45,000 -53,000

Year 1 +24,000 +15000

Year 2 +38,000 +25,000

(Reinvestment

)

-45,000

Year 3 +24,000 +30,000

Year 4 +38,000 +10,000

Determine which machine is strongly suggested to be purchase in order tooptimize the profit return. (Assume that interest rate is 14%)


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(Answer : Machine X, with NPV RM 9,366)Classroom Exercise - Question 1 (Internal Rate of Return)

Internal Rate of Return Computation Statement for Project 1

Duration Initial Cashflow Case 1 0% Case 2 14% Case 3 20% Proved 24.89% Case 4 30%

PV Factor PV PV Factor PV PV Factor PV PV Factor PV PV Factor PV

0 -100 1 -100 1 -100 1 -100 1 -100 1 -100

1 30 1 30 0.877193 26.31579 0.833333 25 0.8007046 24.02114 0.769231 23.076922 40 1 40 0.769468 30.7787 0.694444 27.77778 0.6411279 25.64512 0.591716 23.66864

3 50 1 50 0.674972 33.74858 0.578704 28.93519 0.5133541 25.6677 0.455166 22.75831

4 60 1 60 0.59208 35.52482 0.482253 28.93519 0.411045 24.6627 0.350128 21.00767

NPV 80 26.36788 10.64815 -0.003345 -9.488463

NPV Year

80 0%

26.3679 14%

10.6481 20%

-9.48846 30%

Internal Rate of Return Computation Statement for Project 2

Duration Initial Cashflow Case 1 0% Case 2 14% Case 3 20% Proved 23.05% Case 4 30%

PV Factor PV PV Factor PV PV Factor PV PV Factor PV PV Factor PV

0 -100 1 -100 1 -100 1 -100 1 -100 1 -100

1 60 1 60 0.877193 52.63158 0.833333 50 0.8126778 48.76067 0.769231 46.15385

2 40 1 40 0.769468 30.7787 0.694444 27.77778 0.6604452 26.41781 0.591716 23.66864

3 30 1 30 0.674972 20.24915 0.578704 17.36111 0.5367291 16.10187 0.455166 13.65498

4 20 1 20 0.59208 11.84161 0.482253 9.645062 0.4361878 8.723756 0.350128 7.002556

NPV 50 15.50103 4.783951 0.004102 -9.519975

NPV Year

50 0%

15.501 14%

4.78395 20%

-9.51997 30%

IRR Chart for Project 1

-20

0

20

40

60

80

100

0% 14% 20% 30%

IRR Rate (%)

NetPresentVal

ue(RM)

NPV

Year

IRR Chart for Project 2

-20

-10

0

10

20

30

40

50

60

0% 14% 20% 30%

IRR Rate (%)

NetPresentValue(RM)

NPV

Year

Learning Outcome 1 - Ac 2 (Analytical Methods)

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