Presentation by

FCMA, FPA, MA (Economics), BSc Dubai, United Arab Emirates

Learning Objectives

Background Knowledge
Investment
Refers to an outlay of funds on which management expects a return. An investment creates value for its owners when the expected returns from the investment exceed its cost.

Capital expenditure
Refers to long-term commitments of resources that provide future benefits. Spending by a business to acquire fixed assets (e.g., property, plant, equipment, machinery, vehicles), research and development, massive market campaigns, acquisition and take-over of other Cos., etc.

Why invest?
Businesses need to invest in order to grow. They might want to increase capacity so they can produce more. They could also look to invest to increase the efficiency of their operations.

Definition & Utility

Capital Investment Appraisal (CIA) refers to the complete process of generating/initiating investment proposals, evaluating, ranking and selecting the best alternative(s) and making follow up on investment(s) made. CIA techniques aim to assess the financial feasibility of

investment options. CIA looks at, how an investment opportunity is worthwhile and how it fits to the company strategy and goals???

CIA is used for all types of investment from the purchase of a new piece of machinery to a whole factory!!! CIA allows investment managers to make an informed choice
regarding the viability and acceptability of a project.

Relevant Concepts
Independent investments are projects that can be accepted or rejected regardless of the action taken on any other investment, now or later. Mutually exclusive investments are projects that preclude one another, acceptance of one project means automatic rejection of the other or vice versa. There are two types of mutually exclusive and independent investments replacements and investments in new product and processes.

Nature & Importance

Nature
Long-term rather than short-term. Large investment rather than small investment. More complicated from concerns of future cash flows and/or time value of money. Irreversible in the normal course.

Importance
Large amount of resources are involved that has impact on business strategy, profitability, and survival. Difficult to bail out, once an investment made. The capital investments are challenging and critical to the success of the company. An incorrect decision may end with the companys closing-out from the market. Close relationship with shareholders for their approval.

CIA Process
CIA is a five steps process normally followed by the investment managers in the manner given as below: Initiating, generating and gathering investments ideas.

Analyzing the costs and benefits for proposed investments by: Forecasting costs and benefits for each investment. Evaluating the costs and benefits based on CIA techniques. Ranking the relative superiority of each investment alternative based on financial performance worked out and choosing the best investment opportunity from the given set of opportunities. Implementing the investment alternative chosen. Making follow-up on the investment made on regular basis to see how far this investment opportunity has been effective in the given framework of the company to achieve its desired objectives.

CIA Techniques
A: Traditional Techniques
1. 2. Payback period (PB) Accounting Rate of Return (ARR)

B: Discounted Cash Flow (DCF)/ Time Adjusted (TA) Techniques

1. 2. 3. 4. 5. Net Present Value (NPV) Internal Rate of Return (IRR) Modified Internal Rate of Return (MIRR) Terminal Value (TV) Profitability Index (PI) or Benefit/Cost Ratio

Important Note: These techniques provide theoretically reliable evaluation under conditions of perfect certainty. They are, nevertheless, widely used in practice in the face of uncertainty.

CIA Techniques

NPV PB IRR ARR MIRR TV PI or B/C Ratio

Non-financial Factors
Company Goodwill, Image & Reputation
You may reject an investment opportunity, as it will reflect badly on the company goodwill, image and reputation!!!!!!

Company Policies, Objectives & Culture

You have to check, if the investment conforms to the policies, objectives and culture of the company????

Environmental, Social, Legal & Ethical Issues

Is the investment under consideration, environmentally, socially and ethically acceptable and viable????? There might be legal implications for some investment opportunities.

Impact on Stakeholder Relationships

What is the impact of the investment on competitors, shareholders, employees, buyers, bankers, suppliers and government institutions, etc.,???

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Analyzing Strategic Position for Business Growth & Investment

Business Strength High Medium
Build aggressively invest & grow

Low
Build gradually improve & defend

Market Attractiveness

High

Build aggressively invest & grow

Medium

Build aggressively invest & grow

Build gradually improve & defend

Divest

Low

Build gradually improve & defend

Divest

Divest

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An Illustrative Model
There are two mutually exclusive projects A and B for the consideration of XYZ company. The data for the initial investments and subsequent cash inflows is given on the next slide.

Calculate: PB, ARR NPV, IRR, MIRR, TV, & PI

Important note: This is a very simple model, where initial cash outlays(net investments),
project lives, total of cash inflows over the entire lives, residual values at the end of the projects, interest rates, depreciation charges and tax rates for the projects are all same. There is no further investment after the initial one for the two investing opportunities. Moreover, the projects A and B have continuous stream of cash inflows during the entire period related to them.

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Cash Flows for Projects A & B

Year Project A: Net Cash flows in/(out)
For the year
AED.

Project B: Net Cash flows in/(out)

For the year
AED.

Accumulated
AED.

Accumulated
AED.

0 1 2 3 4

(100,000) 45,000 40,000 35,000 50,000

(100,000) (55,000) (15,000) 20,000 70,000

(100,000) 30,000 30,000 44,000 66,000

(100,000) (70,000) (40,000) 4,000 70,000

The depreciation charge is AED. 20,000 per annum. The residual value for both projects is the same, AED. 20,000 Interest rate is 10% per annum All cash inflows are net-off tax

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1. PB Calculation
Payback period for Project A
= (change in cash flow required to reach zero/total cash flow in the year) + complete years = (15,000/35,000) + 2 = 0.43 + 2 years = 2.43

years

Payback period for Project B

= (40,000/44,000) + 2
= 0.91 + 2 years = 2.91

years Decision Rules

Project A has recovered the initial investment in 2.43 year whereas Project B has recovered initial investment in 2.91 years. Project A has recovered initial investment earlier than Project B, therefore Project A is SELECTED. Important note: A variation of this technique that involves Present Values of cash inflows is known
as Discounted Payback Period. It gives exact idea of recouping of original investment to the business.

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2. ARR Calculation Process

: Calculate annual profit
Annual profit = net cash inflow - depreciation

: Calculate average profit

Average profit = total profits / number of years

: Calculate average capital invested

Average capital invested = (initial cost + residual value) /2

: Calculate ARR
ARR = Average profit/average capital invested x 100

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ARR Calculation
Project A
Average profit = (25,000+20,000+15,000+10,000)/4 = 70,000/4 = 17,500 Average capital invested = (100,000+20,000) /2 = 60,000 ARR = 17,500/60,000 x 100 = 29%

Project B
Average profit = (10,000 + 10,000 + 24,000 + 26,000)/4 = 17,500 Average capital invested = (100,000 + 20,000)/2 = 60,000 ARR = 17,500/60,000 x 100 = 29%

Decision Rules
The Project that has higher ARR is selected. In this case both projects have same ARR. Therefore, results from other techniques shall lead us to final decision.

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Time Value of Money

What is the difference between AED. 1 received now and AED.1 received in a years time???
AED.1 received now has more value than that is received after a year!!!

The factors that change the value of money over a given period of time are given as below: Interest cost
Inflation Other risks to materialise the money

For example
The annual interest rate is 10%, I lend you AED. 1 now and will get back after 1 year, how much worth of that AED.1 in a years time? ? x (1+10%) = AED. 1 ? = AED. 0.909 10% is called cost of capital; ? is called the discount factor

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3. NPV Calculation
The XYZ companys interest rate is 10% p.a. Discount Factors @ 10% p.a. for AED. 1 are as given below: Year 1 = 0.909 Year 2 = 0.826 Year 3 = 0.751 Year 4 = 0.683 Formula to calculate Discount Factor @ 10% p.a. for AED. 1 is given as follows: Discount Factor = 1/(1+10%)^n

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NPV Working for Project A

Project A Net Cash flows in AED. Discount Factor for AED.1 @ 10% p.a. Present Value in AED.

Year
0 1 2 3 4 NPV

1
(100,000) 45,000 40,000 35,000 50,000

2
1.000 0.909 0.826 0.751 0.683

3=1x2
(100,000) 40,905 33,040 26,285 34,150 34,380

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NPV Working for Project B

Project B Cash flow in AED. Discount Factor for AED. 1 @ 10% p.a. Present Value in AED.

Year
0 1 2 3 4 NPV

1
(100,000) 30,000 30,000 44,000 66,000

2
1.000 0.909 0.826 0.751 0.683

3=1x2
(100,000) 27,270 24,780 33,044 45,078 30,172

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NPV Decision Rules

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4. IRR Calculation
IRR is the discount rate which delivers a zero NPV for a given project.

Project A
NPV = AED. 34,380 when the discount rate is 10% NPV = ? When the discount rate is 25%
Cash flow in AED. 1 Discount Factor for AED. 1 @ 25% p.a. 2 Present Value in AED. 3=1x2

Project A
Year

0
1 2 3 4

(100,000)
45,000 40,000 35,000 50,000

1.000
0.800 0.640 0.512 0.410

(100,000)
36,000 25,600 17,920 20,500

NPV

(20)

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IRR Working
Project B
NPV = AED. 30,172 when the discount rate is 10% NPV = ? When the discount rate is 25%
Project A Year 0 1 2 Cash flow in AED. 1 (100,000) 30,000 30,000 Discount Factor for AED. 1 @ 25% p.a. 2 1.000 0.800 0.640 Present Value in AED. 3 = 1x2 (100,000) 24,000 19,200

3 4 NPV

44,000 66,000

0.512 0.410

22,528 27,060 (7,212)

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IRR Decision Rules

Project A: IRR = 25%
Project B: Total change in NPV = 30,172 ( 7,212) = 37,384 Total change in discount rate = 25% 10% = 15% IRR = 10% + 30,172/37,384 x 15% = 22%

Decision rule
For the two mutually exclusive projects A and B, following rule shall be applied:

If Project As IRR>Project Bs IRR then select Project A , & If Project Bs IRR>Project As IRR then select Project B In this case Project As IRR>Project Bs IRR, therefore, Project A is selected.

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5. MIRR Calculation
MIRR is used to gauge an investments attractiveness. It is employed to rank alternative investments of equal size. There are mainly two problems of IRR that are resolved by MIRR.
I. IRR assumes that interim positive cash flows are re-invested at the same rate of return as that of the project that generated them. This is usually an unrealistic scenario and more likely situation is that the funds will be reinvested at a rate closer to the companys cost of capital. IRR, therefore, often gives an unduly optimistic picture of the projects being examined. Generally, for comparing projects more fairly, Weighted Average Cost of Capital (WACC) should be used for re-investing the interim cash flows.

II. More than one IRR can be found for projects with alternative positive and negative cash flows, which leads to confusion and ambiguity. MIRR finds only one value.

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MIRR Formula

MIRR =

, ( , )

-1

Where n is the number of equal periods at the end of cash flows occur.

MIRR can be calculated by using Excel Formula that is given as below: = MIRR(range, finance_rate, reivestment_rate)

Where:
Range: is the range of cells that represent a projects cash flows Finance_rate: is the interest rate that company pays to its banks Reinvestment_rate: is the rate that company expects to receive on reinvestment of cash inflows

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MIRR Decision Rules

Calculation
According to the data given at slide 13, Cost of Capital for the Project A and B is same at 10% p.a. According to the assumption used in the formula for MIRR, the minimum return on re-invested cash inflows is equal to Cost of Capital or Weighted Average Cost of Capital (WACC) instead of IRR of the given projects. MIRR for Project A = MIRR(range, 10%, 10%) = 18.44% MIRR for Project B = MIRR(range, 10%, 10%) = 17.50%

Decision Rules
In case of independent projects, the project having MIRR greater than Cost of Capital is acceptable. For mutually exclusive projects, the project having higher MIRR shall be selected.

Conclusion
Project A has higher MIRR than that of Project B. Therefore, A should be selected according to the criteria established for acceptance and rejection of projects under MIRR.

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6. Terminal Value Calculation

At the end of year 1 2 3 4

Expected rate of return (%) 7 9 6 8

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Terminal Value Working

Yr. RoI YuI CF Net cash inflows Project A 5 AED. 3 1.225 45,000 Total compounded sum for Project A 6=4x5 AED.
55,125 47,520 37,100

Net cash inflows for Project B 7 AED. 30,000

Total compounded sum for Project B 8=4x7 AED.

36,750 35,640 46,640

2 %

2
3 4

9
6 8

2
1 0

1.188
1.060 -

40,000
35,000 50,000 170,000

30,000
44,000 66,000 170,000

50,000

66,000

Total

189,745

185,030

Abbreviations used in the table: RoI: Rate of Interest expected from the market (minimum expected rate can be used) YuI: Years under investment CF: Compounding factor based on given rates Yr.: Year

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Terminal Value Results

Now, we can calculate the Present Value of the compounded sums for Project A and Project B in the following manner: Project A compounded sum x PV factor @ 10% = AED. 189,745 x 0.683 Present Value for Project A compounded sum = AED. 129, 596 Project B compounded sum x PV factor @ 10% = AED. 185,030 x 0.683 Present Value for Project B compounded sum = AED. 126,375

Important Note
A variation of Terminal Value (TV) is based on the pattern of NPV technique and is known as Net Terminal Value (NTV) technique. Symbolically, NTV = PVTS PVO. It has the same Decision Rules that are used for NPV technique. If NTV is positive accept the project and if it is negative then reject it.

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Terminal Value Decision Rules

Decision Rules
For single project, If the Present Value of the Total of compounded re-invested cash inflows (PVTS) is greater than the Present Value of the Outflows (PVO), the proposed project is accepted, otherwise not.
For multiple projects (mutually exclusive projects), the project having PVTS greater than all competing projects when compared with PVOs relating to them, shall be selected.

Symbolically,

PVTS>PVO Accept PVTS<PVO Reject

Conclusion
In both projects PVTS is greater than PVO. Since we have to select any one of them, that is Project A because its PVTS is greater than Project B when both compared with their PVO which is same in this case.

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7. Profitability Index Calculation

Profitability Index (PI) or Benefit/Cost Ratio (B/C Ratio) measures Present Value per Dirham invested. It is a ratio of PV of future cash inflows by PV of cash outlays (ie net investment).

PI = PV of expected cash inflows /PV of cash outflows In keeping with the ongoing illustration, we calculate here PI for Projects A & B. PI for Project A = 134,380/100,000 = 1.344 PI for Project B = 130,172/100,000 = 1.302

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Profitability Index Decision Rules

Decision Rules
If the PI for any single project exceeds 1, the project can be accepted. For the mutually exclusive projects, the project that has higher PI should be considered for investment.

Conclusion
In the given illustration of two Projects A and B, Project A has higher PI than that of Project B. Management can take up Project A for the proposed investment opportunities.

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Decision Rules for all CIA Techniques

Accept or Reject Criteria for
#

Tech.
Single or Independent Project(s)
Mutually Exclusive Projects

1. 2. 3. 4. 5. 6. 7.

PB ARR NPV IRR MIRR TV PI (B/C Ratio)

Less than the Target Period Above the Target Rate A positive NPV Higher than the Target Rate (Cost of Capital)
Higher than Target Cost of Capital (i.e. WACC)

Shortest payback period With the highest ARR With the highest NPV With the highest IRR With higher MIRR
With the highest PVTS>PVO

If PVTS>PVO Accept, And if PVTS<PVO Reject

PI exceeding 1

Higher PI

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Summary of Results from all CIA Techniques

Results for Mutually Exclusive Projects

Accept Project
A or B? A N/A A

#
1. 2. 3.

Technique
A PB ARR NPV 2.43 years 29% AED. 34,380 B 2.91 years 29% AED. 30,172

4.
5. 6. 7.

IRR
MIRR TV PI (B/C Ratio)

25%
18.44% AED. 129,596 1.344

22%
17.50% AED. 126, 375 1.302

A
A A A

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Merits & Demerits of Traditional Techniques

# Tech.

Merits

Demerits

1.

PB

Simple and easy to understand and use. Objective using cash flows. Ignores the time value of Liquidity commercially realistic. money. Cautious & risk averse ignores later Ignores cash flows after the cash flows. payback period. First level estimator gives rough idea about the recouping of the investment. Subjective profit, not cash Simple and easy to understand and use. flows. Aids internal and external Ignores the time value of comparisons. money. Looks at the whole life of the project. Difficulty in use when with A useful tool to measure divisional same ARR and various managerial performance. project sizes.

2.

ARR

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Merits & Demerits of DCF Techniques

# Tech. Merits
Takes account of the time value of money. Instrumental in maximization of shareholder wealth. Takes account of risk. Looks at total benefits over the whole life of the project. Particularly useful for mutually exclusive projects. Takes account of the time value of money. Easy to be understood by managers. Takes into account total cash inflows and outflows.

Demerits
Difficult to be understood by managers. Adverse effects on accounting profits in the short run. How to choose discount rate? May not give satisfactory results where projects have different lives. In case the projects have different cash outlays, it may not give dependable results. Involves tedious calculations. Difficult to use in choosing projects of varying sizes. Difficult to choose when have the same IRR.

1.

NPV

2.

IRR

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Merits & Demerits of DCF Techniques

# Tech. Merits
Quicker to calculate than IRR. MIRR is invariably lower than IRR that may be due to more realistic assumption about reinvestment rate. Explicitly uses re-investment of cash inflows. Mathematically easier. Easier to understand than NPV or IRR. It suits better to cash budgeting. Better technique than NPV in situations where capital rationing issues are involved.

Demerits
There is much confusion about the reinvestment rate used in this formula. One implication of MIRR is that the project may not generate cash flows as predicted and that NPV of the project is overstated.

3. MIRR

4.

TV

The major weakness of this technique that it utilizes interest rates that are uncertain for future cash inflows.
In mutually exclusive projects NPV appears to be superior technique than PI. Difficult to understand.

5.

PI
(B/C Ratio)

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Abbreviations Used
# 1 2 3 4 5 6 Abbreviation AED. ARR CIA DCF IRR MIRR Complete word UAE Dirham Accounting Rate of Return Capital Investment Appraisal Discounted Cash Flow Internal Rate of Return Modified Internal Rate of Return

7 8
9 10 11

NPV NTV
PB PI PVO PVTS

Net Present Value Net Terminal Value

Payback Period Profitability Index (also known as B/C Ratio) Present Value of Cash Outflows
PV of Total Compounded Reinvested Cash inflows

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Capital Rationing
The management has not only to determine the profitable investment opportunities, but it has also to decide about that combination of projects which delivers highest NPV within the available funds.

There are two types of capital rationing.

External Capital Rationing -- Factors that are outside the company due to financial market conditions. Internal Capital Rationing -- Factors that are within the company due to policy, procedure or other constraints.

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Questions & Answers

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Thank you!
Presentation by Ahmad Tariq Bhatti
FCMA, FPA, MA (Eco.), BSc. Mobile #: 00971-50-2024143 Email id: [email protected] Dubai, United Arab Emirates

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