Finance for Non-Financial Managers: Investment Appraisal

Dave JonesBusiness Matters, Finance for Non-Financial Managers0 Comments

Investment Appraisal

Finance for Non-Financial Managers: Investment Appraisal

Investment Appraisal

It’s vital that the investment decisions made by companies are only confirmed once all of the anticipated costs and benefits have been thoroughly analysed.

Investment AppraisalFrom the perspective of the business, funds should only ever be invested if the anticipated financial rewards outweigh the investment costs. So it is vital that accurate costs and benefits are estimated for every investment proposal.

 

Investment Appraisal

When companies make investments, cash inflows and outflows will occur over a fixed period of time. Analysing potential investment decisions relies on knowing when these inflows and outflows will happen as money has what is called a ‘time value’. This means that (measured in constant terms) the value of money declines as we move into the future, compared to what it is worth today.

Companies are only able to make capital investments if they have the necessary funds. This means that companies must make decisions about which investments are the most important. A variety of ranking techniques exist to help managers compare different potential investment projects in terms of how financially beneficial they will be.

Investment AppraisalInvestments should only normally be made if the projected cash inflows offer an acceptable ‘rate of return’. Here, the focus should be on the levels of capital outlay involved, rather than any depreciation charges recorded in the financial statements.
Investment AppraisalIn the context of investment appraisal, the real cost of (for example) using a piece of machinery for a specific project is the potential income sacrificed by not using it for an alternative purpose. So for the purposes of investment decisions, only cash flows are relevant – issues like ‘book value’ and ‘replacement value’ should not be considered. However, in the real world, if an asset was sold for less than its depreciated book value then the loss (in accounting terms) would be recorded on the P&L – which could be of concern to both managers and shareholders.

The payback period method evaluates the simple question of how long it will take to regain the original amount of money invested in the project.

The ‘payback period’ method is a popular means of evaluating potential investment decisions. This is because it’s simple to use, and places relatively less emphasis on predicting cash inflows that occur further in the future – which are necessarily more uncertain. However, it fails to evaluate either risks or the ‘time value’ of money – and ignores cash inflows that occur after the payback period.

Discounting

Assuming that you can make/save 10% (e.g. if interest rates are 10%), $1,100 in one year’s time is worth the same as $1,000 today.

Investment Appraisal
This concept is referred to as that of ‘present value’, and underpins the linked concept of discounted cash flow.
The present value of $1,000 in one year’s time is $909.10. This is worked out according to the following equation: $1,000 / (1 + r) = present value of $1,000. Here, ‘r’ is the interest rate – which we are assuming is 10%. Therefore: $1,000 / (1 .1) = $909.10.
Discounting is a quick and easy method for including the ‘time factor’ of money in the evaluation of potential investment plans. It does this by converting cash flows in the future into their ‘present value’ – e.g. what they are worth today.

Investment AppraisalThe longer you have to wait to get it, the less money is worth in today’s terms.

The discount rate used will be driven by multiple factors, such as the cost of capital. Working out a value for cost of capital is complicated, but vital. It is closely linked to the area of value creation.

The perspective of ‘present value’ can be usefully extended to companies as a whole, in addition to the evaluation of specific investment plans.

For example, projected cash flows relating to existing business operations can also be discounted-back to give a present value. This then allows managers to assess the level of value they are generating for shareholders.

NPV, Discounted Payback and IRR

Investment Appraisal

Net Present Value, Discounted Payback and Internal Rate of Return offer three alternative ways to discount and evaluate project cash flows. They all offer effective ways of quantifying the financial aspects of a potential investment decision by factoring-in the time value of money:

Net Present Value (NPV):

  • NPV involves calculating the Net Present Value of a project, based on a given discount rate.
  • It can be used to decide whether to pursue a given project either in isolation, or in comparison to an alternative project.
  • Every project which has an NPV that is positive should be pursued (at least in terms of financial considerations).
  • However, NPV does NOT assess how much risk is involved in a given project.

Discounted Payback:

  • With the Discounted Payback method, the amount of time required to break even (in present value terms) is calculated.
  • Such an approach may be most useful for high-risk projects.

Internal Rate of Return (IRR):

  • The Internal Rate of Return (IRR) method is perhaps the most popular way of evaluating DCFs. (It is also referred to as ‘DCF rate of return’ or ‘breakeven rate’).
  • IRR is very effective for comparing alternative projects, and assessing both project risks, and risks concerning future capital costs. (High-risk projects require a higher – compensatory – rate).
  • In practice, it requires users to follow a ‘trial and error’ process to work out what the rate will need to be in order to produce an NPV of zero. (Or in other words, the rate whereby the present value generated by the project matches the initial outlay spent on the project).
  • Please note: the smaller the gap is between the IRR and the cost of capital, the more sure you must be of any assumptions you are making.

Sensitivity Analysis

Investment Appraisal

The results of DCF analysis are only as reliable as the assumptions on which it is based. So sensitivity analysis is an approach to testing/varying the assumptions that underlie the DCF measure you are using – and evaluating any alternative outcomes that emerge. Sensitivity analysis essentially requires analysts to ask: ‘what if x happens?’ For example, what happens if:

  • Costs – or sales levels – rise (or fall)?
  • Prices that can be charged fall (or rise)?
  • The project ends up taking 6 years – rather than 4?
  • Capital costs change?
  • Tax rates alter?

The focus of sensitivity analysis should be on the assumptions/variables that could potentially make the biggest impact on the project’s success – or failure. The results generated must be featured in the final proposal for a given investment – and can be very useful if a number of competing potential investments are being assessed.

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