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Learning Objectives By the end of this module you should understand: 1. The three steps in the investment process 2. The concept of present value and its application in investment appraisal: Discounted cash flow Net present value Internal rate of return 3. When to use these three techniques in evaluating projects 4. The impact of risk, uncertainty and inflation in the investment decision, particularly the application of sensitivity analysis 5. How to calculate a company’s cost of capital for discounting purposes. Omar El-Kheshen – omar@arabacademy.com 2
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Agenda 15.1 Introduction 15.2 The Investment Process 15.3 Concept of Present Value 15.4 Discounted Cash Flow Approach 15.5 Net Present Value (NPV) 15.6 Discounted Cash Flow (DCF) Rate of Return 15.7 Comparison of Net Present Value and DCF Rate of Return 15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations 15.9 Risk and Uncertainty and Inflation 15.10 Risk and Uncertainty 15.11 Payoff or Payback Period 15.12 Sensitivity Analysis 15.13 Risk Analysis 15.14 The Key Investment Factors 15.15 Projected Average Cost of Capital 15.16 Average Cost of Capital 15.17 Opportunity Cost, Risk and the Cost of Capital 15.18 Investment Appraisal and Inflation 15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects Omar El-Kheshen – omar@arabacademy.com 3
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There are two types of decisions facing management: investment and operating; the investment decision is more important Investment Decision Operating Decision A decision whose impact extends beyond A decision which has its impact within the the immediate operating period operating period In Financial ReportingIn Financial ReportingIn Financial ReportingIn Financial Reporting These two terms are Synonymous with: CapitalCapital RevenuesRevenues This module is primarily concerned with the financial aspects of the investment decisions underlying capital expenditures Omar El-Kheshen – omar@arabacademy.com 4
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There’s a direct relation between investment decisions and the Return on Capital Employed (ROCE) InvestmentInvestment will increase CapitalCapital DecisionsDecisions EmployedEmployed Therefore denominator will increase: Return on Capital Profit from ordinary activities before taxation = EmployedEmployed Capital employedCapital employed Higher overall profit target has to be set Capital projects often involve large sums of money, therefore the financial consequences of a ‘bad’ or ‘wrong’ decision can be severe Omar El-Kheshen – omar@arabacademy.com 5
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Agenda 15.1 Introduction 15.2 The Investment Process 15.3 Concept of Present Value 15.4 Discounted Cash Flow Approach 15.5 Net Present Value (NPV) 15.6 Discounted Cash Flow (DCF) Rate of Return 15.7 Comparison of Net Present Value and DCF Rate of Return 15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations 15.9 Risk and Uncertainty and Inflation 15.10 Risk and Uncertainty 15.11 Payoff or Payback Period 15.12 Sensitivity Analysis 15.13 Risk Analysis 15.14 The Key Investment Factors 15.15 Projected Average Cost of Capital 15.16 Average Cost of Capital 15.17 Opportunity Cost, Risk and the Cost of Capital 15.18 Investment Appraisal and Inflation 15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects Omar El-Kheshen – omar@arabacademy.com 6
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The investment process involves three quite distinct, although related, processes – search, evaluation and control Search Evaluation Control There is very little thatThere is very little that Finding an apparentlyFinding an apparently Once an investmentOnce an investment accounting can do inaccounting can do in suitable investment hassuitable investment has has been undertaken,has been undertaken, identifying or finding ofidentifying or finding of to be followed by itsto be followed by its the financial control ofthe financial control of suitable investmentsuitable investment evaluation to ascertainevaluation to ascertain it will follow theit will follow the opportunitiesopportunities if it is economicallyif it is economically normal budgetarynormal budgetary worth whileworth while control procedurescontrol procedures All managers have a responsibility to search for worthwhile Control will be through investments monitoring actual income and expenditure and comparing them against the budget or plan The next section is primarily about the framework within which evaluation takes place Omar El-Kheshen – omar@arabacademy.com 7
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Agenda 15.1 Introduction 15.2 The Investment Process 15.3 Concept of Present Value 15.4 Discounted Cash Flow Approach 15.5 Net Present Value (NPV) 15.6 Discounted Cash Flow (DCF) Rate of Return 15.7 Comparison of Net Present Value and DCF Rate of Return 15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations 15.9 Risk and Uncertainty and Inflation 15.10 Risk and Uncertainty 15.11 Payoff or Payback Period 15.12 Sensitivity Analysis 15.13 Risk Analysis 15.14 The Key Investment Factors 15.15 Projected Average Cost of Capital 15.16 Average Cost of Capital 15.17 Opportunity Cost, Risk and the Cost of Capital 15.18 Investment Appraisal and Inflation 15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects Omar El-Kheshen – omar@arabacademy.com 8
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Because of investment decisions’ impact on future time periods, we need a concept that takes into consideration the time value of money €1 Today ≠ €1 one year from now Can be Can be invested consumed and earn immediately and interest, after a we get this year= original €1 benefit nowbenefit now + accumulated+ accumulated interest That’s why the concept uses an interest rate to try to give an equivalent value to monies payable or receivable at different points of time Omar El-Kheshen – omar@arabacademy.com 9
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Note that the concept of present value is different than that of inflation and risk Inflation Risk €1 after a year will not represent the same €1 today €1 after a year will not represent the same purchasing power as Today is safer because you have today’stoday’s it in your pocket now and youit in your pocket now and you don’t know what a year will bring Even in an inflation- and risk-free world there is a time value of money and this is our immediate concern Omar El-Kheshen – omar@arabacademy.com 10
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This concept can best be illustrated through this simple example Example 1 If €100 is invested for one year at annual interest rate of 10%=> it will amount to €110 The original investment of €100 plus the €10 interest Example 2 If the €100 is invested for two years => it will amount to €121 The originalThe original €€100100 plus the first year’s interest ofplus the first year’s interest of €€1010 amounting toamounting to €€110110 plus the secondplus the second year’s interest of €11 (10% of €110) added on to this to give the total amount of €121 This can be simplified as follows: Omar El-Kheshen – omar@arabacademy.com 11
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Then we come up with this general rule for future value of money and present value of money If: n The numbers of yearsThe numbers of years i The rate of interestThe rate of interest Future Any sum invested forAny sum invested for nn years atyears at ii per cent will amount to thatper cent will amount to that Then: Value sum multiplied by (sum multiplied by (11 ++ ii))nn €€100 invested for two years at 10% amounts to100 invested for two years at 10% amounts to €€100100 ×× (1 + 0.10)(1 + 0.10)2 which equalswhich equals €121. This €121 can be referred to as the future value We can use the reciprocal of the equation to calculate the Present Value 1 (1 +(1 + ii))nn A sum of €121 receivable in two years at 10% has a present value today of only €100 Omar El-Kheshen – omar@arabacademy.com 12
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Present value is the sum which would have to be invested today to amount to a given sum at a rate of interest over a given time period Exercise These different values of €200, €170 and €300 receivable or payable at different future times can now be ranked as they have now been reduced to present or equivalent values Omar El-Kheshen – omar@arabacademy.com 13
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Agenda 15.1 Introduction 15.2 The Investment Process 15.3 Concept of Present Value 15.4 Discounted Cash Flow Approach 15.5 Net Present Value (NPV) 15.6 Discounted Cash Flow (DCF) Rate of Return 15.7 Comparison of Net Present Value and DCF Rate of Return 15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations 15.9 Risk and Uncertainty and Inflation 15.10 Risk and Uncertainty 15.11 Payoff or Payback Period 15.12 Sensitivity Analysis 15.13 Risk Analysis 15.14 The Key Investment Factors 15.15 Projected Average Cost of Capital 15.16 Average Cost of Capital 15.17 Opportunity Cost, Risk and the Cost of Capital 15.18 Investment Appraisal and Inflation 15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects Omar El-Kheshen – omar@arabacademy.com 14
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The present value concept forms the basis of what is popularly known as the discounted cash flow approach to the evaluation of investment opportunities Discounted Cash Flow Approach We discount the cash flows arising out of the investment down to a present or equivalent value So that we can:So that we can: Calculate the profitability and/or cost of it Through: Net Present Value (NPV) Internal Rate of Return Omar El-Kheshen – omar@arabacademy.com 15
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Cash flows are either negative or positive Purchase of land and equipment in Cash Cash Outflow (NEGATIVE) Purchase of land and Cash Inflow (POSITIVE) => at the beginning equipment on Credit Cash Outflow (NEGATIVE) => in the future To cover the original purchase price and interest payments Material, labor & Cash Outflow (NEGATIVE) on an ongoing overheads for operations basis When a product is sold Cash Inflow (POSITIVE) Omar El-Kheshen – omar@arabacademy.com 16
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Agenda 15.1 Introduction 15.2 The Investment Process 15.3 Concept of Present Value 15.4 Discounted Cash Flow Approach 15.5 Net Present Value (NPV) 15.6 Discounted Cash Flow (DCF) Rate of Return 15.7 Comparison of Net Present Value and DCF Rate of Return 15.8 Investment Appraisal in Non-Revenue and Not-for-Profit Situations 15.9 Risk and Uncertainty and Inflation 15.10 Risk and Uncertainty 15.11 Payoff or Payback Period 15.12 Sensitivity Analysis 15.13 Risk Analysis 15.14 The Key Investment Factors 15.15 Projected Average Cost of Capital 15.16 Average Cost of Capital 15.17 Opportunity Cost, Risk and the Cost of Capital 15.18 Investment Appraisal and Inflation 15.19 Post-Assessment/Continuous Post-Audit of Capital Expenditure Projects Omar El-Kheshen – omar@arabacademy.com 17
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The net present value approach takes all the cash flows associated with a project and discounts them to a common denominator (PV) using an appropriate interest rate Expected Cash Flows Years Cash flows are discounted (reduced) - using an appropriate - interest rate (cost of - capital or the cost of + finance) + + + NPV Omar El-Kheshen – omar@arabacademy.com 18
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For projects where the manager is faced with a simple accept or reject situation the decision rule is quite simple using NPV IF: The NPV > 0 The rate of return is greater than the cost of ACCEPT financing the project NPV < 0 The rate of return is lower than the cost of REJECT financing the project NPV = 0 The rate of return is equal to the cost of RECONSIDER financing and the project breaks even One of the difficulties associated with net present value is that it is not a concept that enters into everyday business conversation, so not all managers understand it Omar El-Kheshen – omar@arabacademy.com 19
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We will illustrate how difficult it is to translate net present value into the language of management through the following simple example Example Suppose an investment of €300 now will produce cash flows of €114 for the next three years and that the cost of capital is 5%. The cash profile of the investment is as follows: Omar El-Kheshen – omar@arabacademy.com 20
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