Investors Report

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Chapter

Chapter 11

Capital Investment

11.1 Introduction 151 11.2 Payback 152 11.3 Accounting Rate of Return 154 11.4 Discounted Cash Flow 155 11.5 Net Present Value 156 11.6 Internal Rate of Return 159 11.7 Summary 161

Learning Objectives

After completing the study of this unit you should be able to:

• explain the need to make capital investment decisions

• describe the factors to be considered prior to spending capital

• explain the main investment appraisal methods used to assess projects

• carry out simple calculations using each of the methods

• assess critically the different investment appraisal methods.

11.1 Introduction

One of the most important tasks managers face today is choosing the assets in which their business will invest. Investments in long-term capital assets generate revenues or provide cost savings in production, distribution or service areas, usually for more than one year. Because of the long-term commitment of these large expenditures, managers need to minimise the risks involved in the decision-making process.

Worked example 11.1

Belvedere plc has just exceeded its targeted profit for the year. It has no outstanding loans with any long-term creditors. It has no overdraft at the bank. It was able to pay its employees an annual wage rise above the rate of inflation. The annual dividend payment to the shareholders exceeded the previous year’s rate and the market value of its shares is rising. Despite the highly competitive market in which it operates, the business is doing well.

Required

Write down a few reasons why Belvedere plc might still want to make some additional capital investments.

Solution

Whatever the current working environment, the chances are that it is highly competitive, and its pace of change is forever quickening. To maintain competitiveness and market share, Belvedere plc will need to develop business strategies that are dynamic enough to cope with such changes. Those strategies will unquestionably involve capital investment.

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Despite the success of the company the management will consider some of the following reasons for capital investment.

• expansion of existing products and markets

• replacement of assets essential to the continued success of existing products

• diversification into new products and markets

• compliance with health and safety regulations

• enhancement of total quality management

• installation of environmentally friendly working practices

• utilisation of the latest technological advances.

It is often stated that one of the most important decisions facing management is the capital investment decision. It tends to involve a large capital outlay, spent in the knowledge that the gain may not accrue for months or even years, which will affect the profitability of the organisation for many years to come.

It is likely in an organisation that the demand for capital investment funds by managers will greatly exceed the funds available. Therefore, it is important that appropriate methods are used to assess properly which areas of the business should benefit from this capital expenditure.

Investment appraisal methods play a vital role in developing your business strategy by compar- ing, contrasting and optimising the financial returns from the alternative uses of your capital expenditure. In addition to perhaps developing new products for the marketplace, we need to remember that the objective of investment is to increase ultimately the wealth of the investor. Each product or project undertaken should therefore pay back the capital invested in it, as well as providing a return to the investor to compensate for the risks involved. Appraisal, therefore, requires us to forecast four key areas:

• capital outlay

• net cash inflows

• project life

• required rate of return.

This unit considers four investment appraisal methods:

• payback

• accounting rate of return

• net present value

• internal rate of return.

11.2 Payback

The payback period is defined as the number of years it would take for the net cash proceeds generated from the investment to equal the original cost of that investment. The implication here is that the sooner the capital invested is recovered, then the sooner it can be invested in other projects. See worked example 11.2.

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Worked example 11.2

Pentland Ltd can purchase a machine for £600,000 to manufacture cricket bats, which will generate the following cash flows over its five-year useful life.

Year £000s

1 80

2 140

3 180

4 200

5 300

Required

Calculate the prospective investment’s payback period.

Solution

Year Cumulative cash flow

(£000s)

1 80

2 80 + 140 220

3 220 + 180 400

4 400 + 200 600

5 600 + 300 900

Therefore, the payback period is four years because by the end of the fourth year £600,000 will have been generated in terms of the net cash flow from the purchase of the machine, equating exactly to its original cost.

Despite being a very popular investment appraisal technique, the payback period has a number of flaws.

Firstly, it ignores income arising after the payback period. The £300,000 of cash flow in year 5 did not come into the payback calculation. If an alternative investment also had a four-year payback but the cash flow in year 5 had been predicted as £300m rather than £300,000 do you think that might have impacted on the investor’s final decision?

Secondly, the timing of the cash flows is ignored. If an alternative investment had the cash flows noted below, then it would also have had a four-year payback period.

Year £000s

1 510

2 30

3 30

4 30

5 300

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However, there is clearly less risk with the alternative project because it recovers most of its original cost very quickly. The payback method tends to assume that all cash flows are equally certain, but they can be biased in favour of projects having higher cash flows in the early years - to the detriment of projects which require market development and a gradual production build-up before a steady cash inflow can be guaranteed.

Thirdly, the payback method makes it difficult to estimate the net cash flows and to estimate when cash might be received or paid.

Finally, it totally ignores the time value of money, ie £1 today is worth more than £1 will be worth in the future because of the reinvestment potential of the £ held today. This point will be covered more fully later when discussing discounted cash flow (DCF).

In spite of its obvious drawbacks, payback is still a well-used method of investment appraisal today, probably because of the following merits.

• It is easy to understand.

• It is simple to compute.

• It biases a company’s investment programme away from longer-term projects where the risk is greater of future cash flows not being realised.

• It emphasises the importance of cash flow as a dominant factor in the investment decision process.

11.3 Accounting Rate of Return

The accounting rate of return (ARR) method relates the return earned by the investment to its cost, by expressing as a percentage the average annual net profit over the original capital investment. In other words, the emphasis has moved away from the speed with which the original cost was recovered (the payback method) to the volume of profits generated by the investment.

Since an important indicator of business performance is the return on capital employed (ROCE), we might reasonably expect that individual projects should be evaluated in the same way. See worked example 11.3.

Worked example 11.3

Criffel Ltd has the opportunity to invest £800,000 in a four-year project. The estimated annual net profits are as follows.

Year £000s

1 360

2 480

3 280

4 160

Total net profit 1,280

Required

Calculate the accounting rate of return for the project.

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Solution

Average annual net profits Cost of investment

× 100% = £1,280,000 / 4 years

£800,000 × 100% = 40%

We are aware of some of the disadvantages of the payback method, so are we right to assume that ARR must be more accurate? Unfortunately not!

The ARR method also has several disadvantages. Firstly, it gives no indication of what would be an acceptable return. Secondly, like payback it ignores the time value of money, suggesting that a project which produces a gradual build-up of cash inflows over the years is just as preferable as one with a large cash inflow in year one but whose cash inflow tails off over the remaining years of the project’s life.

Thirdly, because the method averages results, it gives no indication of the time span of the return, i.e. a return of 25% over one year is ranked equally with the same annual return over five or ten years. And finally, how should we define profit? Should it be calculated before or after depreciation?

Flawed as the method may seem, the ARR method is still often employed in practice because:

• it is easy to understand and compute

• it emphasises profitability by taking into account the proceeds over the entire life of the project

• the concept of ROCE is familiar to most accountants and managers.

11.4 Discounted Cash Flow

A more sophisticated and increasingly more common investment appraisal consideration is that of discounted cash flow (DCF). There are two main techniques of adopting DCF into project appraisal − net present value (NPV) and internal rate of return (IRR).

• When the cost of supplying funds for a project is known and/or a minimum rate of return is given, you should use the NPV method.

• Where several projects are competing for limited resources available for investment and the funding will be given to the project which provides the highest return, then it is better to use the IRR method.

In order to appreciate fully the workings of these methods, an understanding of the concept of the time value of money is needed.

11.4.1 Time Value of Money

Worked example 11.4

If you invest £2,000 of your money with me today I guarantee to give you back £2,400. Are you interested?

Required

Jot down some of the factors that you might want to consider before handing over the cash.

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Solution

I would imagine that if I was giving you back the £2,400 the following day then you might be very interested because the value of your investment has risen almost immediately by £400.

What would your decision be if the £2,400 was not going to be returned until the same date next year?

The problem is that you cannot directly compare £1 now with £1 in a year’s time because each £1 of present expenditure is not equal in value to each £1 receipt at some stage in the future. Why is this the case?

Cash receivable in the future is generally considered to be worth less than cash received now, because cash that is available now can be reinvested. If you hand me over £2,000 now then you have lost the opportunity to invest this money elsewhere and to generate some interest.

For you to properly assess this investment you need to know what the £2,400 to be received in one year’s time is worth in present value terms. This is called discounting, and by using discount tables (see Appendix 1 at the end of this unit) and choosing an appropriate rate of interest, future cash flows can be brought back to their present value.

Let’s assume that you could put the £2,000 into your building society and receive an annual return of 10%. The 10% would be the appropriate rate of interest to be used in the calculation because this is the rate of return you can earn on an alternative investment. The appropriate rate of interest is known as the cost of capital.

To value your £2,400 in present day terms, simply consult the discount table:

1. Look along the top line for the cost of capital percentage, in this case 10%.

2. Work down the 10% column until you come to the line opposite the year; in our example this is line one.

3. Multiply the cash receivable by the present value of each £1 to be received.

Your £2,400 receivable in one year’s time is worth £2,400 × 0.909 = £2,182 in present value terms, and we can conclude that the investment is still worthwhile.

To check the calculation, if we invested £2,182 in the building society today we would expect it to be worth 10% more than that in one year’s time, ie £2,182 × 1.10 = £2,400.

11.5 Net Present Value

The most straightforward way of determining whether an investment will yield a return in excess of the minimum acceptable rate of return is to calculate the NPV. This is the difference between the present values of the forecasted cash outflows and inflows resulting from the investment. If the NPV is positive, the rate of return is in excess of the required rate. Alternatively, if the rate of return is lower, the NPV will be negative. See Worked example 11.5.

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Worked example 11.5

Hartfell Ltd has the choice of investing in one of two new projects.

Project 1 2

Estimated life 5 years 5 years

£000s £000s

Initial cost (year 0) 2,000 2,000

Net cash inflows

Year

1 600 400

2 800 600

3 1,000 800

4 400 1,000

5 600 600

The company would anticipate being able to generate a rate of return of 10% on alternative investments.

Required

Using the NPV method, which project would you advise Hartfell Ltd to undertake?

Solution

Project 1

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,000 1.000 −2,000

1 600 0.909 545

2 800 0.826 661

3 1,000 0.751 751

4 400 0.683 273

5 600 0.621 373

Net present value 603

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Project 2

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,000 1.000 −2,000

1 400 0.909 364

2 600 0.826 496

3 800 0.751 601

4 1,000 0.683 683

5 600 0.621 373

Net present value 517

As you can see, both projects have a positive NPV. If there is no limitation on the funds available to spend, then all projects with a positive NPV should be chosen. However, our example suggested that Hartfell Ltd had the choice of investing in only one of the two projects. Where funds are limited and, as in this case, the initial investments are the same, then the project with the highest NPV should be chosen. Hartfell would be advised to select project 1 because of its higher NPV.

Let’s assume now that instead of project 1 having an initial investment of £2,000,000, the investment increased to £2,080,000. What impact would that have on the NPV results?

Project 1

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,080 1.000 −2,080

1 600 0.909 545

2 800 0.826 661

3 1,000 0.751 751

4 400 0.683 273

5 600 0.621 373

Net present value 523

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Project 2

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −2,000 1.000 −2,000

1 400 0.909 364

2 600 0.826 496

3 800 0.751 601

4 1,000 0.683 683

5 600 0.621 373

Net present value 517

Obviously there is no change in the NPV position of project 2, but the NPV of project 1 has dropped to £523,000. Would we still be right in assuming that Hartfell Ltd should choose project 1 because of its higher NPV?

In instances where the initial investments are not equal, it is advisable to work out what is known as the profitability index of each project (assuming the index is in excess of 1). The profitability index is calculated by the formula:

Profitability index = Present value of total cash inflows

Initial investment

The relative profitability indices are as follows and highlight that Hartfell Ltd would be advised to choose project 2, as this offers a better ‘return’ on the initial investment.

Project 1 (£000s) 2603 (2080 + 523 ) / 2080 = 1.2514 Project 2 (£000s) 2517 (2000 + 517 ) / 2000 = 1.2585

Like all methods of project appraisal, NPV relies on subjective estimates of the annual net cash flows over the life of the project. Its other major problem is the selection of an appropriate rate of interest, although to choose the rate at which a company could invest its funds externally would appear to be a sensible starting point.

But the NPV does address some of the areas that were weaknesses in the earlier appraisal methods, notably:

• the project’s total profitability

• the return on the original investment

• the timing and present day value of the cash flows.

11.6 Internal Rate of Return

Under the internal rate of return (IRR) method, you are required to calculate the rate of interest that would result in an NPV of zero, i.e. the rate of interest that discounts the future cash flows back to a net present value which equals the capital cost of the project. If the rate of interest calculated is greater than a pre-determined target rate that you have set yourself then the project can be accepted. Alternatively, where several projects are competing, the project with the highest IRR would be selected.

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Computations under IRR are more difficult than under the NPV method and we therefore need to adopt the following procedures.

• Select one discount rate and calculate the NPV of the project.

• If the NPV calculated is positive then keep selecting a higher discount rate until a negative NPV results.

• If the NPV calculated is negative then keep selecting a lower rate until the NPV is positive.

• The rate which will discount the cash flows to zero will be between the two chosen rates and can be calculated using the following formula:

Positive rate + Positive NPV

Positive NPV + Negative NPV × Range of rates

Worked example 11.6

Milk Ltd is considering whether or not to invest £600,000 in a new project which would generate the following net cash flows.

Year £000s

1 240

2 400

3 140

Required

Calculate the internal rate of return for the proposed new project.

Solution

Stage 1

Let us assume that Milk Ltd could invest funds elsewhere and achieve a return of 10% per annum. It could use this as the first trial rate.

Year Cash flow Discount factor NPV

£000s (10%) £000s

0 −600 1.000 −600

1 240 0.909 218

2 400 0.826 331

3 140 0.751 105

Net present value 54

Stage 2

As 10% generated a positive NPV, Milk Ltd need to choose a higher rate. Let’s try 16%.

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Year Cash flow Discount factor NPV

£000s (16%) £000s

0 −600 1.000 −600

1 240 0.862 207

2 400 0.743 297

3 140 0.641 90

Net present value (6)

Stage 3

Because the NPV is negative at 16%, the rate of return at which the project would pay for itself is therefore between 10% and 16%. Applying the formula, the company get the following result.

IRR = 10% + (£000s, 54)(£000s, 54 + 6) × (16% − 10%)

= 10% + (0.9 × 6%) = 15.4%

If this rate is higher than the company’s required rate of return then the project is acceptable.

You will have noticed that IRR very closely resembles the NPV method of project appraisal. They both take account of the time value of money and of the full cash flows of the project, although the IRR can be a time-consuming exercise with its trial and error process of arriving at the final result.

The main disadvantage with IRR is that it completely ignores the scale of the investment. IRR would see a return of 20% being preferable to a return of 15% where the opportunity cost of finance was 10%. However, with a 10% cost of finance, £1 million invested at 15% would increase wealth more than £0.4 million invested at 20%. It should be noted that it is unusual for projects to compete for funds where there is such a large difference in the scale of the investment, and that typically the IRR method will give the same signal as the NPV method. However, even though the problem is rare, the NPV method is always more reliable than IRR.

11.7 Summary

In this unit you have studied one of the most important decision-making areas for management today − the need to make capital investment decisions.

You should now be aware that:

• capital investment tends to involve an initial large capital outlay

• the benefits from the investment might not accrue for years to come

• once agreement has been reached on the decision to be taken, it is very difficult to change that course of action.

It is vital, therefore, for management to appraise the key factors involved in the decision before committing to the expenditure.

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You have considered the pros and cons of four methods used in practice today:

• payback

• accounting rate of return (ARR)

• net present value (NPV)

• internal rate of return (IRR).

We concluded that although in most cases NPV and IRR will give more accurate and usually very similar results, the simplicity of payback and ARR ensures that they also have a role to play in capital investment decision-making.