INVESTMENT Rehman Ayesha ANALYSIS

Course: FINANCE 4/29/2010

TABLE OF CONTENTS
CONTENTS
Letter Of Authorization Letter Of Transmittal Acknowledgement Introduction Payback ROCE IRR NPV APV ROA MIRR ARR Bibliography

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ACKNOWLEDGEMENT
First of all I would like to thank Almighty Allah, for the completion and compilation of this report. Secondly, I really have to express my gratitude towards my parents because this report would never have been possible without the immense cooperation and support they rendered towards me. They responded positively to help me with my assignments and helped me tremendously with the projects undertaken. They let me embark on such an exhilarating experience and journey that helped me learn a lot. Finally, I would really like to thank my respected teacher for his enlightening suggestions and advises. His professionalism, guidance, thoroughness, dedication and inspirations will always serve to me as an example in my professional life.

INTRODUCTION:
Investment is the commitment of money or capital to purchase financial instruments or other assets in order to gain profitable returns in form of interest, income, or appreciation of the value of the instrument. It is related to saving or deferring consumption. Investment is involved in many areas of the economy, such as business management and finance no matter for households, firms, or governments. An investment choice involves the choice by an individual or an organization such as a pension fund, after some analysis or thought, to place or lend money in a vehicle, instrument or asset, such as property, commodity, stock, bond, financial derivatives (e.g. futures or options), or the foreign asset denominated in foreign currency, that has certain level of risk and provides the possibility of generating returns over a period of time. [1] The investment decision (also known as capital budgeting) is one of the fundamental decisions of business management: Managers determine the investment value of the assets that a business enterprise has within its control or possession. These assets may be physical (such as buildings or machinery), intangible (such as patents, software, goodwill), or financial. Assets are used to produce streams of revenue that often are associated with particular costs or outflows. All together, the manager must determine whether the net present value of the investment to the enterprise is positive using the marginal cost of capital that is associated with the particular area of business. The goal of the investment is for producing future cash flows, while at others it may be for purposes of gaining access to more assets by establishing control or influence over the operation of a second company (the investee) [2] Processes: The Techniques for Capital budgeting involves:

Payback ROCE IRR Net Present Value Adjusted Present Value Cost Benefit Analysis Real Option Analysis MIRR ARR

PAYBACK:

Payback period in capital budgeting refers to the period of time required for the return on an investment to "repay" the sum of the original investment. For example: A $1000 investment which returned $500 per year would have a two year payback period. The time value of money is not taken into account. Payback period intuitively measures how long something takes to "pay for itself." All else being equal, shorter payback periods are preferable to longer payback periods. Payback period as a tool of analysis is often used because it is easy to apply and easy to understand for most individuals, regardless of academic training or field of endeavor. When used carefully or to compare similar investments, it can be quite useful. As a stand-alone tool to compare an investment with "doing nothing," payback period has no explicit criteria for decision-making. The payback period is considered a method of analysis with serious limitations and qualifications for its use, because it does not properly account for the time value of money, risk, financing or other important considerations, such as the opportunity cost. Whilst the time value of money can be rectified by applying a weight average cost of capital discount, it is generally agreed that this tool for investment decisions should not be used in isolation. Alternative measures of "return" preferred by economists are net present value and internal rate of return. An implicit assumption in the use of payback period is that returns to the investment continue after the payback period. Payback period does not specify any required comparison to other investments or even to not making an investment.

Formula
There is no formula to calculate the payback period, excepting the simple and nonrealistic case of the initial cash outlay and further constant cash inflows or constant growing cash inflows. To calculate the payback period an algorithm is needed. It is easily applied in spreadsheets. The typical algorithm reduces to the calculation of cumulative cash flow and the moment in which it turns to positive from negative. Additional complexity arises when the cash flow changes sign several times, that is it contains outflows in the midst or at the end of the project lifetime. The modified payback period algorithm may be applied then. Firstly, the sum of all of the cash flows is
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calculated. Then the cumulative positive cash flows are determined for each period. The modified payback period is calculated as the moment in which the cumulative positive cash flow exceeds the total cash outflow. [3]

ROCE:
Return on Capital Employed (ROCE) is used in finance as a measure of the returns that a company is realizing from its capital employed. It is commonly used as a measure for comparing the performance between businesses and for assessing whether a business generates enough returns to pay for its cost of capital.

The formula

ROCE compares earnings with capital invested in the company. It takes into account sources of financing.

Operating Income In the numerator we have pre-tax operating profit or operating income. However, it is also possible to adjust the EBIT by deducting the sum of the taxes. In the absence of non-operating income, operating income agrees with EBIT; otherwise, it can be derived from EBIT by subtracting non-operating income. Capital Employed In the denominator we have net assets or capital employed instead of total assets. Capital Employed in general is the capital investment necessary for a business to function. It is commonly represented as total assets less current liabilities or fixed assets plus working capital.

Applications
ROCE is used to prove the value the business gains from its assets and liabilities. A business which owns lots of land but has little profit will have a smaller ROCE to a business which owns little land but makes the same profit. It can be used to show how much a business is gaining for its assets, or how much it is losing for its liabilities.
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Drawbacks of ROCE
The main drawbacks of ROCE are: It measures return against the book value of assets in the business. As assets are depreciated the ROCE will increase even though cash flow has remained the same. Thus, older businesses with depreciated assets will tend to have higher ROCE than newer, possibly better businesses. While cash flow is affected by inflation, the book value of assets is not. Consequently revenues increase with inflation while capital employed generally does not (as the book value of assets is not affected by inflation). [4]

INTERNAL RATE OF RETURN

Definition
The internal rate of return on an investment or potential investment is the annualized effective compounded return rate that can be earned on the invested capital. The IRR of an investment is the interest rate at which the costs of the investment lead to the benefits of the investment. This means that all gains from the investment are inherent to the time value of money and that the investment has a zero net present value at this interest rate.

Uses
As internal rate of return is a rate quantity, it is an indicator of the efficiency, quality, or yield of an investment. This is in contrast with the net present value, which is an indicator of the value or magnitude of an investment. An investment is considered acceptable if its internal rate of return is greater than an established minimum acceptable rate of return or cost of capital. In a scenario where an investment is considered by a firm that has equity holders, this minimum rate is the cost of capital of the investment. This ensures that the investment is supported by equity holders since, in general, an investment whose IRR exceeds its cost of capital adds value for the company (i.e., it is profitable).

Calculation
Given the (period, cash flow) pairs (n, Cn) where n is a positive integer, the total number of periods N, and the net present value NPV, the internal rate of return is given by r in:

[5]

Problems with using internal rate of return

As an investment decision tool, the calculated IRR should not be used to rate mutually exclusive projects, but only to decide whether a single project is worth investing in.

Net present value

In finance, the net present value (NPV) or net present worth (NPW) of a time series of cash flows, both incoming and outgoing, is defined as the sum of the present values (PVs) of the individual cash flows. NPV is a central tool in discounted cash flow (DCF) analysis, and is a standard method for using the time value of money to appraise long-term projects. Used for capital budgeting, and widely throughout economics, finance, and accounting, it measures the excess or shortfall of cash flows, in present value terms, once financing charges are met. The NPV of a sequence of cash flows takes as input the cash flows and a discount rate or discount curve and outputting a price; the converse process in DCF analysis, taking as input a sequence of cash flows and a price and inferring as output a discount rate (the discount rate which would yield the given price as NPV) is called the yield, and is more widely used in bond trading.

Formula
Each cash inflow/outflow is discounted back to its present value (PV). Then they are summed. Therefore NPV is the sum of all terms,

, where t - the time of the cash flow i - the discount rate (the rate of return that could be earned on an investment in the financial markets with similar risk.) Rt - the net cash flow (the amount of cash, inflow minus outflow) at time t (for educational purposes, R0 is commonly placed to the left of the sum to emphasize its role as (minus the) investment.

Result
The result of this formula if multiplied with the Annual Net cash inflows and reduced by Initial Cash outlay will be the present value but in case where the cash flows are not equal in amount then the previous formula will be used to determine the present value of each

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cash flow separately. Any cash flow within 12 months will not be discounted for NPV purpose.

NPV Means
NPV is an indicator of how much value an investment or project adds to the firm. With a particular project, Rt as a positive value If Rt is a positive value, the project is in the status of discounted cash inflow in the time of t. Rt as a negative value If Rtis a negative value, the project is in the status of discounted cash outflow in the time of t. Appropriately risked projects with a positive NPV could be accepted. This does not necessarily mean that they should be undertaken since NPV at the cost of capital may not account for opportunity cost, i.e. comparison with other available investments. In financial theory, if there is a choice between two mutually exclusive alternatives, the one yielding the higher NPV should be selected. The following sums up the NPVs in various situations.

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If...

It means...

Then...

NPV the investment would > 0 add value to the firm

the project may be accepted

the investment would NPV subtract value from the the project should be rejected <0 firm

the investment would NPV neither gain nor lose =0 value for the firm

We should be indifferent in the decision whether to accept or reject the project. This project adds no monetary value. Decision should be based on other criteria, e.g. strategic positioning or other factors not explicitly included in the calculation.

Drawbacks:

If for example the Rt are generally negative late in the project (e.g., an industrial or mining project might have clean-up and restoration costs), then at that stage the company owes money, so a high discount rate is not cautious but too optimistic. Some people see this as a problem with NPV. A way to avoid this problem is to include explicit provision for financing any losses after the initial investment, that is, explicitly calculates the cost of financing such losses.

Another common pitfall is to adjust for risk by adding a premium to the discount rate. Whilst a bank might charge a higher rate of interest for a risky project, that does not mean that this is a valid approach to adjusting a net present value for risk, although it can be a reasonable approximation in some specific cases. One reason such an approach may not work well can be seen from the foregoing: if some risk is incurred resulting in some losses, then a
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discount rate in the NPV will reduce the impact of such losses below their true financial cost. A rigorous approach to risk requires identifying and valuing risks explicitly, e.g. by actuarial or Monte Carlo techniques, and explicitly calculating the cost of financing any losses incurred.

Yet another issue can result from the compounding of the risk premium. R is a composite of the risk free rate and the risk premium. As a result, future cash flows are discounted by both the risk-free rate as well as the risk premium and this effect is compounded by each subsequent cash flow. This compounding results in a much lower NPV than might be otherwise calculated. The certainty equivalent model can be used to account for the risk premium without compounding its effect on present value.

If NPV is less than 0, which is to say, negative, the project should not be immediately rejected. Sometimes companies have to execute an NPV-negative project if not executing it creates even more value destruction. Another issue with relying on NPV is that it does not provide an overall picture of the gain or loss of executing a certain project. To see a percentage gain relative to the investments for the project, usually, Internal rate of return is used complimented to the NPV method. [6]

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Adjusted Present Value (APV)

Adjusted Present Value (APV) is a business valuation method. APV is the net present value of a project if financed solely by ownership equity plus the present value of all the benefits of financing. The method is to calculate the NPV of the project as if it is all-equity financed. Then the NPV is adjusted for the benefits of financing.

Benefits
The main benefit is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing at sub-market rates. The APV method is especially effective when a leveraged buyout case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial.

Technically, an APV valuation model looks pretty much the same as a standard DCF model. APV and the standard DCF approaches should give the identical result if the capital structure remains stable.

APV formula
APV = Base-case NPV + PV of financing effect

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Cost-benefit analysis
Cost-benefit analysis is a term that refers both to:

Helping to appraise, or assess, the case for a project or proposal, which itself is a process known as project appraisal; and An informal approach to making economic decisions of any kind.

The process involves weighing the total expected costs against the total expected benefits of one or more actions in order to choose the best or most profitable option. Benefits and costs are often expressed in money terms, and are adjusted for the time value of money, so that all flows of benefits and flows of project costs over time are expressed on a common basis in terms of their present value. Closely related, but slightly different, formal techniques include: Cost-effectiveness analysis.

Economic impact analysis. Fiscal impact analysis and Social Return on Investment (SROI) analysis.

The latter builds upon the logic of cost-benefit analysis, but differs in that it is explicitly designed to inform the practical decision-making of enterprise managers and investors focused on optimising their social and environmental impacts.

Theory
Costbenefit analysis is typically used by governments to evaluate the desirability of a given intervention. It is heavily used in today's government. It is an analysis of the cost effectiveness of different alternatives in order to see whether the benefits outweigh the costs. The costs and benefits of the impacts of an intervention are evaluated in terms of the public's willingness to pay for them (benefits) or willingness to pay to avoid them (costs). The process involves monetary value of initial and ongoing expenses vs. expected return.
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Costbenefit calculations typically involve using time value of money formulas. This is usually done by converting the future expected streams of costs and benefits into a present value amount.

Application and history

Costbenefit analysis is used mainly to assess the monetary value of very large private and public sector projects. This is because such projects tend to include costs and benefits that are less amenable to being expressed in financial or monetary terms as well as those that can be expressed in monetary terms. Private sector organizations tend to make much more use of other project appraisal techniques, such as rate of return, where feasible. The practice of costbenefit analysis differs between countries and between sectors (e.g., transport, health) within countries. Some of the main differences include the types of impacts that are included as costs and benefits within appraisals, the extent to which impacts are expressed in monetary terms, and differences in the discount rate between countries. Agencies across the world rely on a basic set of key costbenefit indicators, including the following:

NPV (net present value) PVB (present value of benefits) PVC (present value of costs) BCR (benefit cost ratio = PVB / PVC) Net benefit (= PVB - PVC) NPV/k (where k is the level of funds available)

Accuracy problems
The accuracy of the outcome of a costbenefit analysis depends on how accurately costs and benefits have been estimated. Several studies indicate that the outcomes of costbenefit analyses should be treated with caution because they may be highly inaccurate. In fact, inaccurate costbenefit analyses may be argued to be a substantial risk in planning, because inaccuracies of the size documented are likely to lead to inefficient decisions. These outcomes are to be expected because such estimates:
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1. Rely heavily on past like projects 2. Rely heavily on the project's members to identify the significant cost drivers 3. Rely on very crude heuristics to estimate the money cost of the intangible elements 4. Are unable to completely dispel the usually unconscious biases of the team members and the natural psychological tendency to "think positive" Another challenge to costbenefit analysis comes from determining which costs should be included in an analysis (the significant cost drivers). This is often controversial because organizations or interest groups may think that some costs should be included or excluded from a study. [8]

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Real options analysis

In financial theory, real options analysis or ROA applies put option and call option valuation techniques to capital budgeting decisions. A real option itself, is the right to undertake some business decision; typically the option to make, abandon, expand, or shrink a capital investment. For example: The opportunity to invest in the expansion of a firm's factory, or alternatively to sell the factory, is a real option. ROA, as a discipline, extends from its application in Corporate Finance, to decision making under uncertainty in general, adapting the mathematical techniques developed for financial options to "real-life" decisions.

Comparison with standard techniques

ROA is often contrasted with more standard techniques of capital budgeting, such as net present value (NPV), where only the most likely or representative outcomes are modeled, and the "flexibility" available to management is thus "ignored". The NPV framework therefore (implicitly) assumes that management will be "passive" as regards their Capital Investment once committed, whereas ROA assumes that they will be "active" and may modify the project as necessary. The real options value of a project is thus always higher than the NPV - the difference is most marked in projects with major uncertainty.

More formally, the treatment of uncertainty inherent in investment projects differs as follows: Under ROA, uncertainty inherent is usually accounted for by risk-adjusting probabilities. Cash flows can then be discounted at the risk-free rate. Under DCF analysis, on the other hand, this uncertainty is accounted for by adjusting the discount rate, or the cash. These methods normally do not properly account for changes in risk over a project's lifecycle and fail to appropriately adapt the risk adjustment.
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Valuation
As above, ROA is distinguished from other approaches in that it takes into account uncertainty about the future evolution of the parameters that determine the value of the project, and management's ability to respond to the evolution of these parameters. It is the combined effect of these, which makes ROA technically more difficult than its alternatives. Essentially:

The project is modeled in terms of:

uncertainty: the volatility in the change in value over time is usually proxied as the volatility of project NPV; value: the starting value is usually proxied via management's best guess as to NPV.

Management's ability to respond to changes in value is modeled at each decision point as a series of:

options to contract the project options to abandon the project options to expand or extend the project Switching options, composite options or rainbow options which may also apply to the project.

Drawbacks
Limitations as to the use of these models arise due to the contrast between Real Options and financial options, for which these were originally developed. The main difference is that the underlying is often not tradable e.g. the factory owner cannot easily sell the factory upon which he has the option. This results in difficulties as to estimating the value and volatility of the underlying which are key valuation inputs - this is further complicated by uncertainty as to management's actions in the future. Further, difficulties arise in applying therational pricing assumptions which underpin these option models: often the "replicating portfolio approach", as opposed to Risk neutral valuation, must be applied. Additional difficulties include the fact that the real option itself is also not tradeable e.g. the factory owner cannot sell the right to extend his factory to
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another party, only he can make this decision; however, some real options can be sold, Some real options are proprietary (owned or exercisable by a single individual or a company); others are shared (can be exercised by many parties). Therefore, a project may have a portfolio of embedded real options; some of them can be mutually exclusive. [9]

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Modified internal rate of return

Modified internal rate of return (MIRR) is a financial measure of an investment's attractiveness. It is used in capital budgeting to rank alternative investments. As the name implies, MIRR is a modification of the internal rate of return (IRR) and as such aims to resolve some problems with the IRR.

Problems with the IRR

While there are several problems with the IRR, MIRR resolves two of them. First, IRR assumes that interim positive cash flows are reinvested at the same rate of return as that of the project that generated them. The IRR therefore often gives an unduly optimistic picture of the projects under study. Generally for judging the projects more fairly, the weighted average cost of capital should be used for reinvesting the interim cash flows. Second, more than one IRRs can be found for projects with alternating positive and negative cash flows, which leads to confusion.

Calculation
MIRR is calculated as follows:

, where n is the number of equal periods at the end of which the cash flows occur PV is present value (at the beginning of the first period) FV is future value (at the end of the last period). The formula adds up the negative cash flows after discounting them to time zero, adds up the positive cash flows after factoring in the proceeds of reinvestment at the final period, then works out what rate of return would equate the discounted negative cash flows at time zero to the future value of the positive cash flows at the final time period
[10]

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Accounting rate of return

Accounting rate of return or ARR is a financial ratio used in capital budgeting. The ratio does not take into account the concept of time value of money. ARR calculates the return, generated from net income of the proposed capital investment. The ARR is a percentage return. Example: Say, if ARR = 7%, then it means that the project is expected to earn seven cents out each dollar invested. If the ARR is equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. When comparing investments, the higher the ARR, the more attractive the investment.

Formula

where

[11]

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Bibliography:
[1] http://en.wikipedia.org/wiki/Investment#cite_note-0 [2} http://en.wikipedia.org/wiki/Investment#cite [3] http://en.wikipedia.org/wiki/Payback_period [4] http://en.wikipedia.org/wiki/ROCE [5] http://en.wikipedia.org/wiki/Internal_rate_of_return [6] http://en.wikipedia.org/wiki/Net_present_value [8] http://en.wikipedia.org/wiki/Cost-benefit_analysis [9] http://en.wikipedia.org/wiki/Real_option [10] http://en.wikipedia.org/wiki/Modified_Internal_Rate_of_Return [11] http://en.wikipedia.org/wiki/Accounting_rate_of_return

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