Financial Decision Making-5

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MN7029 – Financial Decision Making for Managers

Session 3.1

Lecture recordings

This session is being recorded

You can access the weekly recording from Weblearn

This Photo by Unknown Author is licensed under CC BY-SA

Learning Outcomes

Explain the nature and importance of investment decision making

Identify and evaluate the four main investment appraisal methods

Use each of the four methods to reach a decision on a particular investment opportunity

Explain the key steps in the investment decision-making process

Maximising Shareholder Wealth

£1m funds available

Bank – interest rate ?%

Investment – return ??%

Dividend – shareholders decide where to invest… ??%

A reminder – the role of the management is to maximise shareholder wealth. In order to do so excess funds either need to be invested in the bank, re-invested in the business in profitable opportunities or returned to the shareholders via dividend so they can make the decision where to invest for maximum return. To day we are looking at the second of these – investigating whether reinvestment in capital projects is going to achieve the aim of maximising the wealth of the shareholders so that the management team can decide whether to proceed.

What is a capital investment project?

Ask the class to see if any have ideas about what we are talking about

What is a capital investment?

Using money to buy fixed assets, or otherwise expand the business

Not day to day operational expenses (working capital)

Capital investment is using money to buy fixed assets or expand the business in some way (e.g. undertake research in to a new product). It is not the working capital or every day expenses of the business

Sources: https://www.bbc.co.uk/news/uk-england-somerset-55823575

https://www.insidermedia.com/news/midlands/new-1.7m-starbucks-site-sold

Some capital investment projects take years and years and cost huge amounts of money – building this nuclear plant is a capital investment project and will take 10 years and cost between £22 and £23bn. Starbucks opening a new coffee shop is also a capital investment project but only takes 6 months and costs £2.7m which is being funded from the company’s own available cash.

The nature & importance of investment decisions

Large amounts of resources are often involved

Relatively long timescales are involved

Often difficult or expensive to bale out of an investment once undertaken

Why are these decisions important?

Figure 4.1 Annual and cumulative cash flows over time for the development of a successful therapeutic drug

Source: Adapted from: ‘Biotech Economics and Valuation’ Massachusetts Biotechnology Council and L.E.K. Consulting, August 2009, p. 3. Reprinted with permission from L.E.K. Consulting. L.E.K. Consulting is a registered trademark of L.E.K. Consulting, LLC. All other products and brands mentioned in this document are properties of their respective owners.

Research into new drugs is another example of a capital investment project which takes years. This example shows expenditure on drug research over 6 years before product launch and then another 4-5 years after the before the drug breaks even

Capital Budgeting

https://www.investopedia.com/terms/c/capitalbudgeting.asp

Investopedia video on capital budgeting

Figure 4.8 Managing the investment decision

How does this fit into decision making? Companies will go through this process:

Determine how much cash is available

Identify projects that could be undertaken

Get more detail on each of the potential projects

Figure 4.8 Managing the investment decision (Continued)

4. Use the tools we are about to look at to evaluate and rate the projects

5. Make a decision on which one(s) to proceed

6. Monitor the budget and control the project

Investment appraisal methods

Four methods of evaluation

Accounting rate of return (ARR)

Payback period (PP)

Net present value (NPV)

Internal rate of return (IRR)

These are the 4 methods we use to evaluate the projects – we will look at each one in turn

Accounting rate of return (ARR)

Average annual operating profit Average investment to earn that profit

ARR =

× 100%

Average annual operating profit Average investment to earn that profit

ARR =

× 100%

The first is a traditional accounting method of project evaluation. This is the Accounting Rate of Return – it takes the average operating profit for each year of the project and divides by the average investment. This is then multiplied to give a percentage return. It is very similar to Return on Capital Employed which we looked at in financial ratios

ARR example

Year	Cost	Operating profit
Now (Year 0)	(160,000)
Year 1		20,000
Year 2		40,000
Year 3		60,000
Year 4		60,000
Total		180,000

I am deciding whether to buy a new machine for £160,000

In years 1 to 4 it generates the profit to the left totalling £180,000. On average this is £45,000 per year

Average investment is (Cost of machine + any disposal value )/2 which is £80,000

x 100 = 56.25%

A machine costs £160k. If I buy it now (which we refer to as Year 0) I will be able to generate profits for the next four years as per this table. The total profits generated are £180k and if we divide by 4 we get an average profit per year of £45k. The average investment is calculated by the value of the machine at the start (£160k) and the value at the end (in this case there is no scrap value so 0) and finding the average i.e. add together and divide by 2 (£80k). Finally the ARR is calculated by dividing the average profit by the average investment and multiplying it by 100. This project has an ARR of 56.25%, meaning a return of £56 earned on the average capital. This in itself does not tell us however whether we should proceed with the project.

ARR decision rule

Where competing projects exceed the minimum rate, the one with the highest ARR should be selected

For a project to be acceptable, it must achieve at least a minimum target ARR

In order to decide whether to proceed we need a decision rule. In the case of ARR, companies need to set a target. If the project ARR exceeds the target it can go ahead. In the case of 2 projects, you would choose the one with the largest ARR.

Problems with ARR

Ignores the timing of cash flows

Use of average investment

Use of accounting profit

Competing investments

Problems:

Uses accounting profit rather than cash (which is more subjective) and ignores the timing – we will talk much more on timing issues later

It also has uses average investment which is not a real cash flow and doesn’t necessarily help us choose between competing investmnets

Payback period (PP)

Time taken for initial investment to be repaid out of project net cash inflows

Payback period is even more simple – it calculates how long it takes for the cash spent on the project to be repaid by the cash flows coming in on the project.

Example 4.1 (Atrill p150)

Time		£’000	Cumulative
Immediately	Cost of machine	(100)
In 1 year	Net cash inflow	20
In 2 years	Net cash inflow	40
In 3 years	Net cash inflow	60
In 4 Years	Net cash inflow	60
In 5 years	Net cash inflow	20

The easiest way to calculate this is to present it like this. In Year 0 we have a cash outflow as we have purchased a machine for £100k. We then get cash coming in from the project over the next 5 years. We add a cumulative column to see how long it takes tp offset the cash out.

Ask class to fill in a couple of cumulatives

Example 4.1 (Atrill p150)

Time		£’000	Cumulative
Immediately	Cost of machine	(100)	(100)
In 1 year	Net cash inflow	20	(80)
In 2 years	Net cash inflow	40	(40)
In 3 years	Net cash inflow	60	20
In 4 Years	Net cash inflow	60	80
In 5 years	Net cash inflow	20	100

Payback Period is 3 years. If we received the £60k evenly over year 3 (i.e. £5k per month) it would take 8 months to receive £40k and PP is therefore more accurately 2 years and 8 months

PP decision rule

If competing projects have payback periods shorter than maximum payback period, the one with the shortest payback period is selected

Project should have a shorter payback period than the required maximum payback period

As with ARR the payback period itself doesn't give us an answer whether tp proceed with the project. We need a decision rule. Companies need to get a target payback period and provided the project payback period is shorter we can proceed. If we have two competing projects we would choose the one with the shorter period.

Problems with PP

Does not take timing of cash flows fully into account

Ignores cash flows after PP

Does not take risk fully into account

Not related to wealth maximisation objective

Arbitrarily determined target payback period

This also has problems.

The first two are illustrated over the next slides

It is subjective because the company chooses the target and it doesn’t take into account risk – e.g. one project may have a shorter PP but be riskier.

It is not directly related to wealth maixmisation

Time		Project 1 £’000	Project 2 £’000	Project 3 £’000
Immediately	Cost of machine	(200)	(200)	(200)
In 1 years time	Cash inflow	70	20	70
In 2 years time	Cash inflow	60	20	100
In 3 years time	Cash inflow	70	160	30
In 4 years time	Cash inflow	80	30	200
In 5 Years time	Cash inflow	90	30	460

Comparing 3 projects with Payback Period (p158)

Take these three projects as an example. All have an initial outlay of £200k and generate cash flows as shown in the table

Time		Project 1 £’000	Cumulative	Project 2 £’000	Cumulative	Project 3 £’000	Cumulative
Immediately	Cost of machine	(200)	(200)	(200)	(200)	(200)	(200)
In 1 years time	Cash inflow	70	(130)	20	(180)	70	(130)
In 2 years time	Cash inflow	60	(70)	20	(160)	100	(30)
In 3 years time	Cash inflow	70	0	160	0	30	0
In 4 years time	Cash inflow	80		30		200
In 5 Years time	Cash inflow	90		30		460

Comparing 3 projects with Payback Period (p158)

If we do the payback period calculation, all have a payback period of 3 years so we are indifferent as to which one we would chose.

Figure 4.2 Cumulative cash flows for each project in Activity 4.6

Source: Adapted from Atrill, P. and McLaney E. (2009) Accounting: An Introduction, 5th edn, Pearson Education.

However if we present the payback like this we can see that project 3 has a much larger payout after the payback period – this is effectively ignored by the payback period method. Also Project 2 has most of the back in period 3, whereas project 1 and 3 have a more even spread. This problem with the payback period method leads us to consider the time value of money.

Both methods assume that £100 received in Year 4 is the same as £100 received in Year 1.

But is it?

The methods we have looked at until now assume that £100 received in year 4 is the same as £100 received now. Is this the case.

As the class – If I offer you either £100 now or £100 in 4 years, which would you choose? Why?

Video about time value of money

NPV investment appraisal method

Makes a logical allowance for the timing of those cash flows

Considers all of the cash flows for each investment opportunity

The next methods we will consider is Net Present Value and this has an advantage over payback period as it takes into account all the cash flows and when they are received.

Figure 4.3 Factors influencing the return required by investors from a project

Source: Atrill, P. and McLaney, E. (2009) Accounting an Introduction, 5th edn, Pearson Education.

What causes us to place different values on cash depending on when it is received? The three elements to the time value of money are as above (explained on next slide)

Time value of money

Interest lost – an investment return must exceed the opportunity cost of doing something else with the money e.g. if a company could get a return of 5% simply by putting it in the bank, they should only make the investment if the return exceeds that.

Risk – All investments have risk – there could be risks that the projections do not work out as planned, or that a piece of machine could break down, or a pandemic could hit… When making an investment the manger must consider the risk and will expect a higher return the higher the risk.

Inflation – the loss in the purchasing power of money means that £100 in one year will not be able to buy the same amount as £100 now, therefore returns must compensate for this.

Explanation of time value

Maximising Shareholder Wealth

£1m funds available

Bank – interest rate 1%

Investment – return ??%

Dividend – shareholders decide where to invest… ??%

Rate of return > Pure Time Value + Inflation+ Risk Premium

Going back to our decision making, the investment return must compensate for the opportunity cost, inflation and risk

The present value of a cash flow

PV of the cash flow of year n = actual cash flow of year n divided by (1 + r) n

The NPV method looks at each cash flow and when it arises in the future and assigns a present value to it.

For example receiving £105 in Year 1, might only be equivalent to receiving £100 today. We then add up all those cash flows to give a total value of the project today

NPV applies time value by examining each future cash flow and assigning a value to it to represent what it is worth today (i.e. the present value). For example receiving £105 in a year’s time might be equivalent to receiving £100 today – we need to receive more in the future to equate to the same value. The equation for calculating today’s value of a future cash amount is shown here. r represents an appropriate discounting rate to take account of inflation, opportunity cost and risk

The future value of a deposit

FV of a deposit of £100 at 5%= £100(1+0.05)n

In year 1 (n=1) the FV is £105, in year 2 the FV is £110.25 and so on

It can sometimes help to look at this in the other direction. If I deposit £100 today (Year 0) at a rate of 5% in one year the future value is £105, in 2 years £110.25. This is compounding forwards. Discounting works the other way – if I expect to receive £105 in one year at a rate of 5% how much do I need to deposit (or spend in the case of our capital investment) today to get that £105

Ways to calculate Present Value

Using discount tables

Using the formula

Using calculations in Excel

Using Excel formulas

I am going to show you 4 ways to calculate the net present value of the future cash flows of an investment. All give the same answers so you can use whichever method you are most comfortable with.

Using discount tables

Prepare the cash flow for each year of the project

Select the column representing the discount rate (cost of capital) you will use in the table

For each period find the multiplier and multiply the cash flow for that period by it

Add up all of the present values to give you the Net Present Value (NPV)

Apply rule - If NPV is positive, it increases shareholder wealth therefore accept project.

Steps to calculate NPV using discount tables

Example of NPV using 20%

Time

Project 1 £’000

Project 2 £’000

Project 3 £’000

Time	Cash flow £’000	Multiplier (from the discount table)	Present value
Immediately (year 0)	(100)	1	(100)
1 Years time	20	0.833	16.66
2 Years time	40	0.694	27.76
3 Years time	60	0.579	34.74
4 Years time	60	0.482	28.92
5 Years time	40	0.402	16.08
Total - NPV			24.16

Investing in the machine will increase wealth of business and owners by £24,160 therefore accept.

Walk through the example making sure students can identify where each multiplier is coming from on the discount table. Make the point that to finalise this NPV calc you need to add up the Present Value and deduct the original cost of the machine – students seem to forget the final step.

Figure 4.4 Present value of £1 receivable at various times in the future, assuming an annual financing cost of 20 per cent

This demonstrates that the discount rates are really just a short cut to the formula that we look at next.

Using mathematical equation

Prepare the cash flow for each year of the project

Calculate the PV of each

Add up all of the present values to give you the Net Present Value (NPV)

Apply rule - If NPV is positive, it increases shareholder wealth therefore accept project.

If you prefer, rather than using the discount rates, you can take a step even further back and use the equation that the discount rates are derived from. Again you still need to prepare a cash flow and then you calculate the PV for each year and then add them all up

Investing in the machine will increase wealth of business and owners by £24,190 therefore accept.

If NPV is positive, project should be accepted.

If comparing two projects with positive NPV accept the higher.

Time	Cash flow £’000	Formula	Present value
Immediately (year 0)	(100)		(100.00)
1 Years time	20	20/	16.67
2 Years time	40	40/	27.78
3 Years time	60	60/	34.72
4 Years time	60	60/	28.94
5 Years time	40	40/	16.08
Total - NPV			24.19

You will get the same answer as using the discount tables – the tables are really just a short cut from this method.

Mathematical equation in excel


	A			B
Time	Cash flow	1 + discount rate	To the power of	Equals	Present value (A/B)
Year 0	-100	1.2	0	1.00	-100.00
Year 1	20	1.2	1	1.20	16.67
Year 2	40	1.2	2	1.44	27.78
Year 3	60	1.2	3	1.73	34.72
Year 4	60	1.2	4	2.07	28.94
Year 5	40	1.2	5	2.49	16.08

Total					24.18

=POWER(1.2,1)

If you like Excel you can calculate the present values using the POWER formula

PV Function in Excel

Even more easily you can use the function Present Value or PV in Excel. Once you have brough up the function box you fill in the rate, the year in Nper and the future value (i.e. the future cash flow) and the formula will calculate the PV for you.

There is a detailed step by step video on Weblearn showing you how to use this function in Excel.

NPV decision rule

If competing projects are positive, the one with the highest NPV is selected

If NPV is positive, it increases shareholder wealth therefore accept.

NPV shows whether the future cash flows from a project will increase the value of a company at today’s values. Therefore, any project that has a positive NPV will increase the value of the company and increase shareholder wealth and should therefore be accepted. If there are competing projects you should choose the one with the higher NPV as that increases wealth more than the other.

Why NPV is better than ARR and PP

The whole of the relevant cash flows

The objectives of the business

The timing of the cash flows

NPV fully addresses each of the following:

NPV has a number of advantages over the other methods so far

Internal rate of return (IRR)

The discount rate, which, when applied to the future project cash flows, produces a zero NPV

The final tool we use is linked to NPV. Internal Rate of Return shows the discount rate that would give a NPV of zero

On a particular project, the higher the discount rate used, the lower the NPV, until it will eventually move into a loss

Time	Cash flow	Present Value at 20%	Present Value at 25%	Present Value at 30%	Present Value at 35%

Year 0	-100	-£100.00	-£100.00	-£100.00	-£100.00
Year 1	20	£16.67	£16.00	£15.38	£14.81
Year 2	40	£27.78	£25.60	£23.67	£21.95
Year 3	60	£34.72	£30.72	£27.31	£24.39
Year 4	60	£28.94	£24.58	£21.01	£18.06
Year 5	40	£16.08	£13.11	£10.77	£8.92

Total		£24.18	£10.00	-£1.86	-£11.87

This si easiest to see in an example. When we calculated the NPV of the project we calculated that at a rate of 20% the project had an NPV of £24,180. If we increased the discount rate then the NPV starts to fall, so at 25% it is £10,000 and eventually it becomes negative – at 30% it is negative £1,860. Therefore, there must be a discount rate that will give an NPV of Zero – i.e. the barrier between accepting and rejecting the project. This either needs to be done by trial and error – as above – we can guess that the IRR will be slightly lower that 30%, probably around 29% based on those figures, or we can use Excel and there is a video that shows you how to do this on Weblearn.

Figure 4.5 The relationship between the NPV and IRR methods

Source: Adapted from Atrill, P. and McLaney E. (2009) Accounting: An Introduction, 5th edn, Pearson Education.

If we wre to plot NPV and rate of return on a graph we can see where it crosses the X axis is the IRR

IRR decision rule

If competing projects exceed minimum IRR requirement, the one with the highest IRR is selected

Project must meet a minimum IRR requirement (The opportunity cost of finance)

Again we need a decision rule and again in this case it is a target set by the company.

On this project, IRR is about 30% - if this is higher than the minimum target the project should go ahead

If competing projects, the one with the highest IRR should be selected.

Present Value at 30%

-£100.00
£15.38
£23.67
£27.31
£21.01
£10.77

-£1.86

IRR decision Making

Explanation of decision making

An example of where companies use IRR in decision making e.g. Legoland owned by Merlin have a target IRR of 14% on their capital investments. Rentokill use IRR hurdles in different departments to reflect different risk profiles

Problems with IRR

Does not directly address wealth maximisation

Ignores the scale of investment

Has difficulty with unconventional cash flows

Problems with IRR

Unconventional cash flows have two or more changes of sign in the cash flows

Some practical points related to investment appraisal

Year-end assumption

Cash flows not profit flows

Interest payments

Other factors

Past costs

Common future costs

Opportunity costs

Taxation

Practical points:

Do not include past costs – these are gone. Only include future costs

Do not include common future costs e.g. if you have a worker on the project who you would need to pay anyway this does not get included in the calculation.

Do include opportunity costs. If buying a new machine means you can sell the old one, that is additional revenue you can include

Tax is something to consider in real life, but too complicated to go into here.

Remember NPV and IRR and PP use cash flows, not accounting profit

Year end assumptions relate to things like additional working capital needed, we have-not gone into this here

Interest payments again have not been looked at here

Remember that finance is just one element – there may be other factors you need to consider

Figure 4.7 The main investment appraisal methods

Source: Adapted from Atrill, P. and McLaney, E. (2013) Accounting and Finance for Non-Specialists, 8th edn, Pearson Education.

A summary of methods

Summary of the key features

Investment appraisal in practice

Many surveys have shown the following features:

NPV and IRR have become increasingly popular

Continued popularity of the PP and ARR methods

Businesses tend to use more than one method

Larger businesses rely more heavily on NPV and IRR than smaller businesses

In practice…

Response scale

IRR

NPV

1 - never

5 - always

USA

Germany

Canada

Japan

Average

3.88

3.46

4.00

3.89

4.16

3.50

3.33

4.08

4.09

3.57

4.15

3.57

3.52

3.29

3.80

3.55

3.93

Frequency of use of investment appraisal techniques

Source: Based on information in G. Cohen and J. Yagil (2007) ‘A multinational survey of corporate financial policies’, Journal of Applied Finance. vol 17(1).

In practice…

What’s Next…

Today

5.30 – 7.30 Capital Investment Decision Making continued

7.30 – 8.30 Business Simulation Round 5

8.30pm – Finish!

For next time:

Business Simulation round 5 submitted by 3pm Wednesday 11th January

Assessment 1 – Thursday 12th January 2022 for groups 1 & 2 and Friday 13th January for groups 3,4 & 5

Financial Decision Making-5

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