INVESTMENT EVALUATION.

In its simplest form, an investment decision can be defined as one which involves the firm in making a cash outlay with the aim of receiving, in return, future cash inflows greater than the initial cash outflow. It follows that an investment decision has a large implication for a firms cash flows initially with the outflow of cash upon the purchase of the asset and thereafter with the future inflows of cash as a result of the asset ownership. Therefore, the starting point of any investment evaluation must be with the construction of the CASH-FLOW FORECAST, ie;- identification of the quantities and timings of all the cash flows into and out of the firm. (NOTE;- for the purposes of cash-flow forecasting, money not flowing out of the company due to the ownership of an asset is perceived as money flowing into the company, ie;- a saving in salaries is money not flowing out of the company, this is therefore perceived as a positive inflow of money to the company as far as investment evaluation is concerned.)

EXAMPLE:- Your company, a medium size manufacturing company, manufactures a range of engine management systems for sale as original equipment to the automotive manufacturing market. This market is expected to grow at 10% per year for the next 5 years. The current production line is just about at capacity, although you are currently working a two shift system to maintain current production levels. An alternative to recruiting additional labour is to invest in CNC machines, which will increase the capacity of your production to absorb the expected growth in demand for at least the next five years on a single shift basis. The purchase of 3 new CNC machines will form the basis of a flexible manufacturing cell. The CNC machines will cost 250,000 each, and are expected to last for 5 years, after which they will be sold off for 25,000 each. The additional dedicated tooling for your current production range will cost a further 80,000 in total and a further 25,000 will be required for material handling equipment, etc. The maintenance of the tooling and associated equipment will be done in-house at an estimated cost of 5,000 per year, but because your maintenance department does not have the experience/expertise to maintain the CNC machines, a contract will be taken out at a cost of 10,000 per year. It is further estimated that a saving of 5,000 per year in reduced scrap/rework should be realised, and the existing 8 old capstan lathes can be sold off for 2,500 each. The new cell will be operated by 3 programmer/operators recruited out of the existing workforce of 16 machinists, who are currently paid 20,000 each inclusive of shift premium etc. Following training, at a cost of 10,000, (to be paid within the first 3 months), they will be paid a salary of 22,000 per year each. The remaining 13 machinists can be considered as a saving, together with a maintenance fitter who currently earns 18,000 per year. Your companys current cost of capital is 10%.

Using the above information it is necessary to construct a CASH-FLOW FORECAST showing the timings and quantities of all the expected cash flows;0 BENEFITS;machinists, 13@20k. maintenance fitter@18k scrap/rework cnc m/c scrap value 3@25k capstan scrap value 8@2.5k TOTAL BENEFITS;COSTS;cnc m/c. 3@250k tooling. matl. handling equip. cnc m/c maintenance tooling maintenance. prog/ops. 3@2k training TOTAL COSTS;750 80 25 855 10 5 6 10 31 10 5 6 21 10 5 6 21 10 5 6 21 10 5 6 21 20 20 260 260 18 18 5 5 283 283 260 18 5 283 260 18 5 283 260 18 5 75 358 1 2 3 4 5

NET CASH FLOW:-

(835)

252

262

262

262

337

PAYBACK METHOD. This is one of the most tried and trusted of all investment appraisal methods and its name neatly describes its operation, referring to how quickly the incremental benefits that accrue to a company from an investment project PAYBACK the initial capital invested. EXAMPLE;Year 0 1 2 3 (3.225yrs) 4 5 cash-flow (835) 252 262 262 cumulative cash-flow. (835) (583) (321) (59) 3+ 262 years. 262 337 203 540
59

PAYBACK = 3.225 years.

Advantages;- quick to use and easy to understand - good for capital rationing - minimises the risks of error (uncertainty) in long-term forecasting. Disadvantages;- doesnt take account of the life of the project - doesnt take account of the time value of money.

RETURN ON INVESTMENT METHOD. In its simplest form it is the average annual return expressed as a percentage of the initial capital employed. (Note;- a variation on this technique is called Accounting Rate of Return however this technique, as the name suggests, is based on PROFIT and therefore is not a cash flow technique in itself). Return on Investment Example;Return on Investment = ROI 32.63% ROI = 32.63%
(20 + 252 + 262 + 262 + 262 + 337) / 5 855

average annual receipts total capital employed

100 1

100 1

(1395) / 5 100 855 1

279 100 855 1

Advantages;- quick to use and understand - expressing a return as a percentage is easily understood - easy to compare with alternatives - directors performance is judged by shareholders return on investment - takes account of the life of the project.

Disadvantages;- a percentage return does not take into account the actual cash-flow benefits to a companys liquidity. - Doesnt take into account the time value of money.

TIME VALUE OF MONEY. The value of money alters with time;1.00 invested today @ 10% interest will increase in value with time, ie;Time PeriodValue0 1.00 1 1.10 2 1.21 3 1.331 4 1.4641 5 1.61051

Therefore when making an investment decision the s spent today are not the same value as the future s. It is therefore necessary to DISCOUNT all the future s to the same value as the s that are being spent today. This is achieved by dividing the actual future cash flows by the compound interest rate (or multiplying by Its reciprocal);Actual cash flow000s 000s 000s 000s 000s 000s

Divide* by1 (Alternatively** by) (1)

1.10 1.21 1.33 1.46 1.61 (.9091) (.8264) (.7513) (.6830) (.6209)

(*Amount of 1 at compound interest: (1+r)n **Present value of 1 at compound interest: (1+r)-n ie discount factors).

This will DISCOUNT all the future cash flows to todays value, ie;- the value of all the future actual cash flows has been discounted back to the same value as the s being spent today. Techniques which make use of this process are called DISCOUNTED CASH FLOW TECHNIQUES.

NET PRESENT VALUE METHOD. This technique calculates the difference between the cost of the investment and the PRESENT VALUE of all the future actual cash flows. An acceptable NET PRESENT VALUE would have a positive value, ie;the sum of all the future actual cash flows discounted to todays value is greater than the initial expenditure. EXAMPLE;Year 0 1 2 3 4 5 cash flow (835) 252 262 262 262 337

10% discount factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209

present value. (835.0000) 229.0932 216.5168 196.8406 178.9460 209.2433

NPV = 195.6399

NET PRESENT VALUE = 195,640

Advantages;- quick to use and easy to understand - takes account of the time value of money - takes into account the life of the project. Disadvantages;- an arbitrary technique, ie- if NPV>1 accept investment proposal - doesnt acknowledge the risks of error (uncertainty) in long term forecasting.

DISCOUNTED PAYBACK METHOD. This is a modified version of the payback method. The technique is the same except that the cast flows arent actual cash flows but the DISCOUNTED CASH FLOWS. EXAMPLE;Year 0 1 2 3 4 yrs. 5 10% cash flow discount factor (835) 1.0000 252 0.9091 262 0.8264 262 0.7513 262 0.6830 = present value. (835.0000) 229.0932 216.5168 196.8406 178.9460 4+ 209.2433 337 0.6209 209.2433 = 4.0650yrs.
13.6034

DISCOUNTED PAYBACK = 4.065 years.

Advantages;- quick to use and easy to understand - good for capital rationing - minimises the risks of error (uncertainty) in long-term forecasting.

Disadvantages;- doesnt take account of the life of the project.

INTERNAL RATE OF RETURN METHOD. This technique calculates the interest rate that would be necessary to give a Net Present Value equal to ZERO. At low interest rates the NPV of an investment will be relatively high, however, as the interest rate increases, the NPV will decrease, until eventually it will become a negative value. Therefore to calculate the point at which the interest rate will give a zero NPV, it is necessary to have a positive NPV and a negative NPV and then interpolate between these two values to find the interest rate which will gives a ZERO NPV. EXAMPLE;Year 0 1 2 3 4 5 cash flow (835) 252 262 262 262 337

10% discount factor 1.0000 0.9091 0.8264 0.7513 0.6830 0.6209

present value. (835.0000) 229.0932 216.5168 196.8406 178.9460 209.2433

NPV = 195.6399 Year 0 1 2 3 4 5 cash flow (835) 252 262 262 262 337

20% discount factor 1.0000 0.8333 0.6944 0.5787 0.4823 0.4019

present value. (835.0000) 209.9916 181.9328 151.6194 126.3626 135.4403 (29.6533)

NPV = IRR;10% +

IRR = 10% +

195.6399 195.6399 ( 29.6533) (20%-10%) 195 . 6399 10% % + 8.68379%) 225 . 2932

= (10 IRR = 18.68%

Therefore, the Internal Rate of Return is approximately equal to 18.68%, however, because a linear interpolation across a curve will give an error, it is possible to get a more accurate figure;Year 0 1 2 3 4 5 cash flow (835) 252 262 262 262 337

18% discount factor 1.0000 0.8475 0.7182 0.6086 0.5158 0.4371

present value. (835.0000) 213.5700 188.1684 159.4532 135.1396 147.3027 8.6339

NPV =

( The NPV is positive, therefore the IRR must be above 18%) Year 0 1 2 3 4 5 cash flow (835) 252 262 262 262 337

19% discount factor 1.0000 0.8403 0.7062 0.5934 0.4987 0.4190

present value. (835.0000) 211.7556 185.0244 155.4708 130.6594 141.2030

NPV = (10.8868)

Therefore;- NPV = 8.6339 @ 18% NPV = (10.8868) @ 19%

8.6339

IRR;IRR =

18% + 8.6339 (10.8868) (19%-18%) 18% +

8.6339 1% 19 . 5207

= (18% + 0.4423%) = 18.44%

IRR =18.44%

Therefore if the company had to pay 18.44% for its capital, (the interest rate the company pays to borrow the funds, or the interest rate the company foregoes by not investing the funds in interest bearing investments), the NPV would be zero ie;- no gain/(loss). Advantages;- takes into account the life of the project - takes into account the time value of money - focuses on one of the critical success factors (the interest rate ) which maybe beyond the companys control. Disadvantages;- it only considers one of the critical success factors others could be equally or more important.

+ve NPV

Linear Interpolation. 195.640

IRR 18.68% 0 10% (29,653) Rate. -ve NPV IRR = 18.44% 20% Interest