Pike Robert, Neal Bill. Corporate finance and investment: decisions and strategy

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Chapter 5 Investment appraisal methods 145

evaluating investment projects and why.

(Certified Diploma)

4 Mr Cowdrey runs a manufacturing business. He is considering whether to accept one of two mutually exclu-

sive investment projects and, if so, which one to accept. Each project involves an immediate cash outlay of

£100,000. Mr Cowdrey estimates that the net cash inflows from each project will be as follows:

Net cash inflow Project A Project B

at end of: (£) (£)

Year 1 60,000 10,000

Year 2 40,000 20,000

Year 3 30,000 110,000

Mr Cowdrey does not expect capital or any other resource to be in short supply during the next three years.

Required

(a) Prepare a graph to show the functional relationship between net present value and the discount rate for

the two projects (label the vertical axis ‘net present value’ and the horizontal axis ‘discount rate’).

(b) Use the graph to estimate the internal rate of return of each project.

(i) 6 per cent; (ii) 12 per cent.

(d) Describe briefly any additional information you think would be useful to Mr Cowdrey in choosing

between the two projects.

(e) Discuss the relative merits of net present value and internal rate of return as methods of investment

appraisal.

Ignore taxation.

(ICAEW)

5 The directors of XYZ plc wish to expand the company’s operations. However, they are not prepared to bor-

row at the present time to finance capital investment. The directors have therefore decided to use the compa-

ny’s cash resources for the expansion programme.

Three possible investment opportunities have been identified. Only £400,000 is available in cash and the

directors intend to limit the capital expenditure over the next 12 months to this amount. The projects are not

divisible (i.e. cannot be scaled down) and none of them can be postponed. The following cash flows do not

allow for inflation, which is expected to be 10 per cent per annum constant for the foreseeable future.

Expected net cash flows (including residual values)

Initial investment Year 1 Year 2 Year 3

Project £ £ £ £

A 95,000 110,000 200,000

B 45,000 45,000 45,000

C 125,00025,00040,00035,000

105,000

350,000

The company’s shareholders currently require a return of 15 per cent nominal on their investment.

Ignore taxation.

Required

(a) (i) Calculate the expected net present value and profitability indexes of the three projects; and

(ii) comment on which project(s) should be chosen for the investment, assuming the company can invest

surplus cash in the money market at 10 per cent. (Note: you should assume that the decision not to

borrow, thereby limiting investment expenditure, is in the best interests of its shareholders.)

(b) Discuss whether the company’s decision not to borrow, thereby limiting investment expenditure, is in the

best interests of its shareholders.

(CIMA)

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146 Part II Investment decisions and strategies

6 Raiders Ltd is a private limited company financed entirely by ordinary shares. Its effective cost of capital, net

of tax, is 10 per cent p.a. The directors are considering the company’s capital investment programme for the

next two years, and have reduced their initial list of projects to four. Details of the projects’ cash flows (net of

tax) are as follows (in £000):

After 1 After 2 After 3 NPV IRR

Project Immediately year years years (at 10%) (to nearest 1%)

A 26%

B 25%

C 23%

D 0 50%159.5300250300

73.5150150150300

150.0400400200300

157.035030050400

None of the projects can be delayed. All projects are divisible; outlays may be reduced by any proportion and

net inflows will then be reduced in the same proportion. No project can be undertaken more than once. Raiders

Ltd is able to invest surplus funds in a bank deposit account yielding a return of 7 per cent p.a., net of tax.

Required

(a) Prepare calculations showing which projects Raiders Ltd should undertake if capital for immediate

investment is limited to £500,000, but is expected to be available without limit at a cost of 10 per cent p.a.

thereafter.

(b) Provide a mathematical programming formulation to assist the directors of Raiders Ltd in choosing

investment projects if capital available immediately is limited to £500,000, capital available after one year

is limited to £300,000, and capital is available thereafter without limit at a cost of 10 per cent p.a.

(d) Comment briefly on the view that in practice capital is rarely limited absolutely, provided that the bor-

rower is willing to pay a sufficiently high price, and in consequence a technique for selecting investment

projects that assumes that capital is limited absolutely is of no use.

(ICAEW)

Either drawing on your own experience, or by asking someone you know in management, find out the primary

investment appraisal techniques employed in an organisation. How well does the appraisal system appear to

operate?

Practical assignment

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Project appraisal – applications

Learning objectives

Having read this chapter, you should be well equipped to handle most capital investment decision

problems found either on examination papers or in business. Skills should develop in the following

areas:

■ Identifying the relevant information in investment analysis.

■ Evaluating replacement and other investment decisions.

■ Handling inflation.

■ Assessing the effects of taxation on investment decisions.

■ Investment appraisal practices, strengths and limitations.

■ Identifying the appropriate discount rate.

To boldly go into space-age investment

There is a danger that investment analysis can

become bogged down in unnecessary detail. So how

does an entrepreneur like Sir Richard Branson, inven-

tor of the Virgin brand, make investment decisions?

Like many other top managers, Branson places

more reliance on experience and ‘hunch’ in deci-

sion-making than detailed financial analyses.

However, he also works through the risks involved

and whether they can be managed. In his autobiog-

raphy, Branson claims to make up his mind about

whether a business proposal excites him within

about thirty seconds of looking at it. He relies more

on gut instinct than researching huge quantities of

statistics. The idea of operating a Virgin airline

grabbed his imagination, but he had to work out

in his own mind what the potential risks were

(Branson, 1998, p. 216).

In 2004 Branson took a giant step in announcing

that he would boldly go into the space age through

his new company – Virgin Galactic – the world’s first

commercial space business. A fleet of five Virgin

spacecraft will carry 3,000 passengers into space

between 2007 and 2012. The company expects to

spend $100 million over five years to develop the

spacecraft and the first Virgin astronauts will have to

pay £105,000 for a flight.

Branson also argues that fun is at the core of the

way he likes to do business and the main secret of

Virgin’s success. He observes that the idea of business

being fun and creative goes right against the grain of

convention, and it’s certainly not how they teach it at

some of those business schools, where, as he puts it,

‘business means hard grind and lots of discounted cash

flows and net present values!’ (Branson, 1998, p. 490).

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148 Part II Investment decisions and strategies

Self-assessment activity 6.1

What do you understand by the term ‘incremental cash flow’?

(Answer in Appendix A at the back of the book)

6.1 INTRODUCTION

In the previous chapter, we examined a variety of approaches to assessing investment

projects. The focus was almost exclusively on the appropriate appraisal method. But

even the best appraisal method is of little use unless we can first identify the relevant

information.

Investment decisions, particularly larger ones with strategic implications, are not

usually made on ‘the spur of the moment’. The whole process, from the initial idea

through to project authorisation, usually takes many months, or even years. A vital

part of this process is gathering information to identify the incremental cash flows per-

taining to the investment decision. In this chapter, we consider the principles under-

lying economic feasibility analysis and apply them to particular situations. We pay

particular attention to the treatment of inflation and taxation in project evaluation.

■ Need for relevant information

In financial management, as with all areas of management, an effective manager needs

to identify the right information for decision-making. In the case of capital investment

decisions, committing a substantial proportion of the firm’s funds to non-routine, large-

ly irreversible actions can be risky and demands a careful examination of all the rele-

vant information available.

Information on the likely costs and benefits of an investment proposal, its expected

economic life, appropriate inflation rates and discount rates should be gathered to pro-

vide a clearer picture of the project’s economic feasibility. Frequently, we find that the

reliability of the information source varies. For example, a demand forecast from a mar-

keting executive with a track record of making wildly inaccurate forecasts will be

viewed differently from an official quote for the cost of a machine. The accounting sys-

tem and formal reports provide a part of the relevant information, the remainder com-

ing through informal channels, frequently more qualitative than quantitative in nature.

In identifying and analysing information, managers should remember that effec-

tive information should, wherever possible, be relevant, reliable, timely, accurate and

cost-efficient.

6.2 INCREMENTAL CASH FLOW ANALYSIS

We stressed in the previous chapter that the financial input into any investment deci-

sion analysis should be based on the incremental cash flows arising as a consequence

of the decision. These can be found by calculating the differences between the forecast

cash flows from going ahead with the project and the forecast cash flows from not

accepting the project.

This is not always easy. To illustrate this point, we consider how investment analy-

sis handles opportunity costs, sunk costs, associated cash flows, working capital

changes, interest costs and fixed overheads.

■ Remember opportunity costs

Capital projects frequently give rise to opportunity costs. For example, a company has

developed a patent to produce a new type of lawnmower. If it makes the product, the

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Chapter 6 Project appraisal – applications 149

expected NPV is £70,000. However, this ignores the alternative course of action: to sell

the patent to another company for £90,000. This opportunity cost is a fundamental ele-

ment in the investment decision to manufacture the product and should be deducted

from the £70,000, giving a negative NPV of £20,000. The in-house production option is

not wealth-creating – and the sale of the patent appears to be more attractive.

Opportunity cost example: Belfry plc

We often see opportunity costs in replacement decisions. In Belfry plc, an existing

machine can be replaced by an improved model costing £50,000, which generates cash

savings of £20,000 each year for five years, after which it will have a £5,000 scrap value.

The equipment manufacturers are prepared to give an allowance on the existing

machine of £15,000, making a net initial cash outlay of £35,000. But in pursuing this

course of action, we terminate the existing machine’s life, preventing it from yielding

£3,000 scrap value in three years. The prospective scrap value denied is the opportuni-

ty cost of replacing the existing machine. The cash flows associated with the replace-

ment decision are therefore:

Year 0 Net cost (£35,000)

Years 1–5 Annual cash savings (£20,000)

Year 3 Opportunity cost (scrap value forgone on old machine) (£3,000)

Year 5 Scrap value on new machine £5,000

■ Ignore sunk costs

By definition, any costs incurred or revenues received prior to a decision are not rele-

vant cash flows; they are sunk costs. This does not necessarily imply that previously-

incurred costs did not produce relevant information. For example, externally

conducted feasibility studies are often undertaken to provide important, technical, mar-

keting and cost data prior to a major new investment. However, the costs of the study

are excluded from project analysis. We are concerned with future cash flows arising as

a particular consequence of the course of action.

■ Look for associated cash flows

Investment in capital projects may have company-wide cash flow implications. Those

involved in forecasting cash flows may not realise how the project affects other parts of

the business – senior management should therefore carefully consider whether there

are any additional cash flows associated with the investment decision. The decision to

produce and launch a new product may influence the demand for other products with-

in the product range. Similarly, the decision to invest in a new manufacturing plant in

Eastern Europe, or to take over existing facilities, may have an adverse effect on the

company’s exports to such countries.

Self-assessment activity 6.2

Waxo plc has developed a new wonder earache drug. The management is currently putting

together an investment proposal to produce and sell the drug, but is not sure whether to

include the following:

1 The original cost of developing the drug.

2 Production of the new product will have an adverse effect on the sale of related prod-

ucts in another division of Waxo.

3 Instead of producing the drug internally, the patent could be sold for £10 million.

How would you advise Waxo on the relevant costs?

(Answer in Appendix A at the back of the book)

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150 Part II Investment decisions and strategies

Self-assessment activity 6.3

Rick Faldo – the marketing manager of a manufacturer of golf equipment — has recently

submitted a proposal for the production of a range of clubs for beginners. He has just

■ Include working capital changes

It is easy to forget that the total investment for capital projects can be considerably more

than the fixed asset outlay. Normally, a capital project gives rise to increased stocks and

debtors to support the increase in sales. This increase in working capital forms part of the

investment outlay and should be included in project appraisal. If the project takes a num-

ber of years to reach its full capacity, there will probably be additional working capital

requirements in the early years, especially for new products where the seller may have to

tempt purchasers by offering more than usually generous credit terms. The investment

decision implies that the firm ties up fixed and working capital for the life of the project.

At the end of the project, whatever is realised is returned to the firm. For fixed assets, this

will be scrap or residual value – usually considerably less than the original cost, except in

the case of land and some premises. For working capital, the whole figure — less the

value of damaged stock and bad debts – is treated as a cash inflow in the final year,

because the finance tied up in working capital can now be released for other purposes.

Occasionally, the introduction of new equipment or technology reduces stock

requirements. Here the stock reduction is a positive cash flow in the start year; but an

equivalent negative outflow at the end of the project should be included only if it is

assumed that the firm will revert to the previous stock levels. A more realistic assump-

tion may be that any replacement would at least maintain existing stock levels, in

which case no cash flow for stock in the final year is necessary.

■ Separate investment and financing decisions

Capital projects must be financed. Commonly, this involves borrowing, which requires

a series of cash outflows in the form of interest payments. These interest charges should

not be included in the cash flows because they relate to the financing rather than the

investment decision. Were interest payments to be deducted from the cash flows, it

would amount to double-counting, since the discounting process already considers the

cost of capital in the form of the discount rate. To include interest charges as a cash out-

flow could therefore result in seriously understating the true NPV.

Some companies include interest on short-term loans (such as for financing season-

al fluctuations in working capital) in the project cash flows. If so, it is important that

both the timing of the receipt and the repayment of the loan are also included. For

example, the NPV on a 15 per cent one-year loan of £100,000, assuming a 15 per cent

discount rate, must be zero: £100,000 cash received today less the present value of

interest and loan repaid after a year (i.e. £115,000/1.15).

■ Fixed overheads can be tricky

Only additional fixed overheads incurred as a result of the capital project should be

included in the analysis. In the short term, there will often be sufficient factory space

to house new equipment without incurring additional overheads, but ultimately some

additional fixed costs (for rent, heating and lighting, etc.) will be incurred. Most facto-

ries operate an accounting system whereby all costs, including fixed overheads, are

charged on some agreed basis to cost centres. Investment in a new process or machine

frequently attracts a share of these overheads. While this may be appropriate for

accounting purposes, only incremental fixed overheads incurred by the decision should

be included in the project analysis.

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Chapter 6 Project appraisal – applications 151

6.3 REPLACEMENT DECISIONS

The decision to replace an existing machine which has yet to reach the end of its useful

life is often necessary because of developments in technology and generous trade-in

values offered by manufacturers. In analysing replacement decisions, we assess the

additional costs and benefits arising from the replacement, rather than the attractive-

ness of the new machine in isolation.

received the following response from the managing director:

To: Rick Faldo

From: Sid Torrance

I have examined your proposal for the new ‘Clubs for Beginners’ range which you say promises

a three-year payback and a 30 per cent DCF return. Some hope! You seem to have forgotten the

following relevant points.

1 We have a policy that all investment is subject to a depreciation charge of 25 per cent on

the reducing balance.

2 The accounting department will need to recover factory fixed overheads on the new

machine.

3 We need to charge against the project the £8,000 marketing research conducted to assess

the size of the market for the new range.

4 I’d have to pay 15 per cent to finance the project.

Projects like this I can do without!

How would you reply to this e-mail if you were Faldo?

(Answer in Appendix A at the back of the book)

Example of replacement analysis: Sevvie plc

Sevvie plc manufactures components for the car industry. It is considering automating its

line for producing crankshaft bearings. The automated equipment will cost £750,000. It will

replace equipment with a residual value of £80,000 and a written-down book value of

£200,000. It is anticipated that the existing machine has a further five years to run, after

which its scrap value would be £5,000.

At present, the line has a capacity of 1.25 million units per annum but, typically, it

has only been run at 80 per cent of capacity because of the lack of demand for its out-

put. The new line has a capacity of 1.4 million units per annum. Its life is expected to

be five years and its scrap value at that time £105,000. The main benefits of the new pro-

posal are a reduction in staffing levels and an improvement in price due to its superior

quality.

The accountant has prepared the cost estimates shown in Table 6.1 based on output of

1 million units p.a. Fixed overheads include depreciation on the old machine of £40,000 p.a.

and £130,000 for the new machine. It is considered that for the company overall, other fixed

overheads are unlikely to change.

The introduction of the new machine will enable the average level of stocks held to

be reduced by £160,000. After five years, the machine will probably be replaced by a sim-

ilar one.

Continued

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152 Part II Investment decisions and strategies

Table 6.1 Profitability of Sevvie’s project

Old line New line

(per unit) (per unit)

(p) (p)

Selling price 150 155

Materials (40) (36)

Labour (22) (15)

Variable overheads (14) (14)

Fixed overheads (34) (40)

Profit per unit 40 50

The company uses a 10 per cent discount rate. We shall ignore taxation.

The solution is given in Table 6.2. Several comments are worthy of note:

1 It has been assumed that no benefits can be obtained from the additional capacity due to

the sales constraints. In reality, it would be useful to explore whether – for example, by

investing in advertising – demand could be increased.

2 Fixed costs are not relevant. Depreciation is not a cash flow, and we are told that other

fixed costs will not alter with the decision. The incremental cash flow per unit is there-

fore 16p, giving

£160,000 (i.e. 1 million units at 16p) additional cash each year on the

expected sales.

3 In addition to the scrap values of

£80,000 in Year 0 and £105,000 in Year 5 on the old

and new machines respectively, there is a

£5,000 opportunity cost in Year 5. This is

the scrap value no longer available as a consequence of the replacement decision.

4 Working capital will be reduced by

£160,000 for the period of the project and it therefore

appears as a benefit in Year 0.

5 The book value of the existing machine represents the undepreciated element of the

original cost, a sunk cost which is not relevant to the decision. The book value of assets,

however, may be important in practice, as it can sometimes mean a heavy accounting

loss in the year of acquisition. In this case, the loss would be

£120,000 (i.e. book value

£200,000 less £80,000 residual value). This is not a cash flow, but, in practice, it may

still be regarded as undesirable to depress reported profit figures in this way. This, of

course, raises issues of market efficiency – will the market see through the accounting

adjustment?

The replacement decision is a wealth-creating opportunity offering an NPV of £157,000,

although the cumulative present value calculation in Table 6.2 shows that the project does

not come into surplus, in net present value terms, until the final year.

Table 6.2 Sevvie plc solution

Old line New line

(pence per unit) (pence per unit)

Selling price 150 155

Less:

Materials (40) (36)

Labour (22) (15)

Variable overheads (14) (14)

Variable costs (76) (65)

Cash contribution 74 90

Incremental cash flow

per unit (90–74) 16p

Total incremental cash £160,000

flow on 1 million unit sales

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Chapter 6 Project appraisal – applications 153

6.4 INFLATION CANNOT BE IGNORED

Inflation can have a major impact on the ultimate success or failure of capital projects.

In considering how it should be treated in discounted cash flow analysis, two problems

arise: first, how does inflation affect the estimated cash flows from the project; and sec-

ond, how does it affect the discount rate?

For example, a machine costs £18,000 and is projected to produce, in current prices,

cash flows of £6,000, £10,000 and £7,000 respectively over the next three years. The

expected rate of inflation is 6 per cent and the firm’s cost of capital is 16.6 per cent.

We can adopt one of two approaches:

1 Forecast cash flows in money terms and discount at the nominal or money cost of

capital including inflation (i.e. 16.6 per cent), or

2 Forecast cash flows in constant (i.e. current) money terms and discount at the real

cost of capital.

‘Money terms’ here means the actual price levels that are forecast to obtain at the

date of each cash flow; ‘constant terms’ means the price level prevailing today; and

‘real cost of capital’ means the net of inflation cost.

In Table 6.3 cash flows expressed at constant prices are converted to actual money

cash flows by compounding at where I is the inflation rate. These cash flows are

then discounted in the normal manner at the money discount factor (the reason for such

an awkward rate will become apparent later) to give a positive NPV of £977. Had we

not adjusted cash flows for inflation, the NPV would have been incorrectly expressed

as a negative value.

11  I2,

Table 6.2 Continued

Year (£000) 0 1 2 3 4 5

Cost savings 160 160 160 160 160

New machine (750) 105

Scrap old machine 80 (5)

Working capital reduction 160

Net cash flow (510) 160 160 160 160 260

Net present value

10% discount factor 1.000 0.909 0.826 0.751 0.683 0.621

Present value (510) 145 132 120 109 161

Cumulative present value (510) (365) (233) (113) (4) 157

NPV 157

Table 6.3

The money terms

approach

Actual Discount

Cash flow money factor Present

Year current prices (£) prices (£) @ 16.6% value (£)

0 (18,000) 1 (18,000)

1 6,360 5,454

2 11,236 8,264

3 8,337 5,259

NPV 977

11.1662

 11.062

7,000

11.1662

 11.062

10,000

1.166

 1.066,000

 1.0118,0002

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154 Part II Investment decisions and strategies

Self-assessment activity 6.4

What is the impact of firms not adjusting their investment ‘hurdle’ rates for changing levels

of inflation? How would you advise a company which employs a 20 per cent discount rate

which was based on a calculation made when inflation was twice the current level?

(Answer in Appendix A at the back of the book)

In this example, we undertook both compounding and discounting. The process

could be simplified by multiplying the two elements. For example, in Year 2 we could

multiply by to obtain a net of inflation discount factor of 0.8264

which, when multiplied by the cash flow in current prices, gives a present value of

£8,264, as stated above. This gives rise to the formula for the real cost of capital, denoted

by P.

Calculating the real cost of capital

where M is the money cost of capital, I is the inflation rate and P is the real cost of capital.

In our example, this gives us a real cost of capital of:

Applying the real cost of capital gives the same NPV as before, as shown in Table 6.4.

While the latter approach may be simpler, it is not without difficulties. In business,

the use of a single indicator of the rate of inflation, such as the Retail Price Index, may

be inappropriate. Selling prices, wage rates, material costs and overheads rarely

change at exactly the same rate each year. Rent may be fixed for a five-year period;

selling prices may be held for more than a year. Furthermore, when taxation is intro-

duced into the analysis, we find that tax relief on capital investment is not subject to

inflation. Such complexities lead us to recommend that both cash flows and discount

rates should include inflation.

P 

1.166

1.06

 1  0.10, i.e. a rate of 10 per cent.

P 

1  M

1  I

 1

11  P2 

1  M

1  I

1>11.1662

11.062

Table 6.4

The real terms

approach

Cash flow Real discount

Year current prices (£) rate @ 10% PV (£)

0 (18,000) 1 (18,000)

1 6,000 5,454

2 10,000 8,264

3 7,000 5,259

NPV 977

11.12

1.1

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