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Append below the explanation of terminal cash flows and a simple example as illustration:
Terminal Cash Flows:
Illustration:
Company XYZ intends to buy a new machine to increase its present sales. The machine costs $200,000 with five years of useful life and its salvage value is $25,000. By buying this machine, the company will incur additional yearly working capital requirements of $10,000. Calculate the terminal cash flows.
Solution:
Terminal cash flows= Salvage value = $25,000 + working capital recovered of $10,000 = $35,000
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As Investment Appraisal entails substantial initial capital outlay and years( at least more than one year) to reap the benefits, the analyst needs to ensure that he or she should pick up the relevant data when performing such appraisal otherwise the company will suffer. Hence, it is critically important to understand some of the cardinal principles or rules or guidelines when performing this Investment appraisal exercise.
Append below in brief pertaining to:
GUIDELINES/PRINCIPLES ON THE CAPITAL BUDGETING ANALYSIS Guideline No1: Use Cash Flows And Not Accounting Profit. Remember that profit is not equating to cash. You need to adjust accounting profit to arrive at the relevant cash flows Guideline No 2: Focus on Incremental Cash flows. Simply it means that you should compare the total cash flows of the company with and without the project. After determining the incremental cash flows, you need to consider the tax implication on these cash flows viz focus only on “after-tax incremental cash flows” in the capital budgeting analysis. Guideline No.3: Consider any synergistic effect on the project for example when this new product the firm is going to introduce, will the sales of the existing products also increase- are they complementary to each other. In financial terms therefore we need to consider the sales of the new products Plus the increase in sales of the existing products Guideline No.4: Consider the opposite of rule no 3 re: the existing sales might reduce with the introduction of the new products. Factored the loss of revenue from such existing products into the capital budgeting analysis Guideline No.5: Ignore sunk costs and consider only those costs which are relevant to the projects. Guideline No.6: Incorporate any NET additional working capital requirements into the capital budgeting analysis for example the need to have additional inventories, accounts receivables and or cash (increase in current assets) minus additional financing from accounts payable, bank borrowings(current liabilities) Guideline No.7: Excludes Interest Payments as this is already reflected in the discount rate ( this rate implicitly accounts for the cost of raising the financing ) |
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Earlier article explain what’s capital budgeting and its importance.
Append below explains the process, types of capital projects and capital budgeting decisions a firm needs to embark on:
Capital Budgeting Process Involves :
Types Of Capital Budgeting Projects:
Types Of Capital Budgeting Decisions:
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Below explain the meaning of capital budget and its importance:
Capital Budgeting:
Importance of Capital Budget:
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We have reviewed the four methods of investment appraisal techniques:
The pros and cons of the payback, accounting rate of return and internal rate of return have been explained.
Fundamentally, the greatest disadvantage of the payback and accounting rate of return is that it ignores the time value or the present value of the inflows.
For accounting rate of return, besides ignoring the time value, it only refers to the accounting profit.As such, though they are simple to compute and understand, it’s not a true investment appraisal method as risk in the form of discount rate or cost of capital is completely not considered.
For Internal rate of return, the disadvantages have been outlined in my article.
Net Present Value method (NPV) has the following advantages:
When there is no budget constraints, Net present value (NPV) is particularly appropriate compared to other alternative investments method. The Internal rate of return cannot work well if it is comparing two mutually exclusive investment projects of different size or scope.
Even though, where we have budget constraints, we can also use the profitability index which is actually net present value reinstated ( present value of cash flows divide by investment outlay)
In view of the foregoing, the most appropriate or superior method should be the net present value or other method that uses discounted cash flow technique.
Interpretation:
If the PI is more than one, then we should invest in the project as it represents a positive net present value.
Usefulness of Profitability Index:
The Profitability Index is useful tool for capital budget constraints and where the projects are divisible. This is true as you will have noticed that net present value (NPV) method tends to favor large investments over smaller one. However, in reality, a company is often operating under capital budget constraints, either fixed by the markets or by top management. This therefore makes NPV method as a less flexible tool.
Assuming the following scenario:
Budget constraints of $300,000
Total following investment cost of 5 projects more than $500,000
| Project | Investment | Present Value | Profitability Index | NPV |
| A | 100K | $141K | 1.41 (141/100) | $41K |
| B | 200K | $240K | 1.20 (240/200) | $40K |
| C | 82K | $120K | 1.46 (120/82) | $38K |
| D | 150K | $170K | 1.13 (170/150) | $20K |
| E | 50K | $85K | 1.70 (85/50) | $35K |
As we have the budget constraints of $300K, using the Profitability Index method, we should select the following projects to maximize our net present value:
Project E + Project C + Project A + part of Project B
Investment costs of $50K+$82K+$100K+$68K=$300K
NPV =$35K+$38K+$41K + pro-rate NPV of Project B=68/200×40K=$13.6=$127.6K
Limitation of Profitability Index:
As we have read above, the Profitability Index is merely another way of reinstating net present value. However, when coming to choose between two mutually exclusive projects which have a positive NPV and profitability indices of more than one, we see certain limitation of this index. This is similar to the situation mentioned in my earlier IRR’s article
Illustration:
| Project | Investment | Present Value | Profitability Index | NPV |
| A | $10K | $16K | 1.6 | $6K |
| B | $30K | $42K | 1.4 | $12K |
If we use the Profitability Index method, then we should select Project A which has a higher PI than Project B but then Project B actually has a very much higher net present value.
We can further verify this by using the incremental cash flow and seeing whether they fulfil the profitability index decision rule:
| Investment | Present Value | Profitability Index | NPV | |
| Differential between A & B | $20K | $26K | 1.3 | $6K |
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In basic term, net present value (NPV) of an investment is the difference between:
The present value of future cash flows and the present value of the initial capital expenditure required to implement the project.
Say for example the following project having the follow details:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using NPV: | |||||
| PV Factor © | 1.000 | 0.909 | 0.826 | 0.751 | 0.683 |
| Present Value (a*c) or (b*c) | - $100K | +$18.18K | +$24.78K | +$30.04K | +$34.15K |
| Net Present Value | +$7.15K |
Interpretation of NPV:
If the project has a positive NPV, it should be accepted. By acceptance, it will increase the shareholders value as it gives a higher return compared to its cost of capital ( in this case is the PV factor or discount factor which we assume is 10%)
It’s important to understand that normally, a positive NPV implies excess returns over its cost of capital. But in economic theory, it will not happens in an efficient and competitive market as competitiveness will remove the opportunities to make excess returns from capital expenditures.
Of course in the real world, we have imperfection, however it’s interesting to note and rationalize the source of the positive NPV or the excess return. Is it from any superior technological expertise, R&D, trademarks and patents, market knowledge & skill, quality control, distribution network, after sales service and client relations or the caliber of management and employees? By identify the competitive factors that generate positive NPV , we are able to understand better the reasons for the project’s profitability.
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We have looked at how we compute investment appraisal method using Net Present Value(NPV) and Internal Rate Of Return(IRR) and also understand how to interpret the individual result.
One very good point is that both NPV and IRR are able to eliminate the greatest disadvantage of ignoring the time value of money or present value unlike the other two methods -Payback and ARR.
We now focus on the advantages of using IRR:
IRR is useful for the following reasons:
However IRR also has its critique which is as follows:
Say for example, if we are choosing two investment projects with capital outlays of $1,000 and $10,000 and the IRR of the $1,000 is higher. If we use the IRR method than the IRR which is higher will be more attractive. However, the Net Present Value of the other investment could be much high and so we make have made a less than perfect decision. Therefore, the IRR method is not suitable for making comparisons between two investment projects of different scope or differing time horizons.
For illustration purpose that IRR is not suitable to be used when we need to choose between two mutually exclusive investments:
| Year | Project A Investment | Cash-flows | Project B Investment | Cash- flows |
| 0 | -$100K | -$40K | ||
| 1 | $40K | $20K | ||
| 2 | $50K | $20K | ||
| 3 | $70K | $30K | ||
| NPV @10% | $20K(say) | $10K(say) | ||
| IRR | 15% | 22% |
Project A should be chosen if the NPV method was used whilst Project B should be chosen according to its IRR. But, by taking the differential/remaining cash-flows and calculating the NPV and IRR, we can see that this would have been a less than perfect decision.
Differential Balance of Cash-flow
| Year | Investment Project A – B | Cash-flows |
| 0 | -$60K | |
| 1 | $20K | |
| 2 | $30K | |
| 3 | $40K | |
| NPV @10% | $6K(say) | |
| IRR | 14% |
The differential table shows that there is still value to be gained to enhance shareholder value by investing the differential.
The other disadvantages of IRR are:
How do we then interpret a zero NPV
Zero NPV is actually the Internal Rate of Return which is therefore the discount rate that causes:
The present value of all the future cash flows – the present value of the initial outlay to yield an NPV of zero.
Using the same cash flow’s details from the NPV case, we shall try to get the IRR:
| Year O | Year 1 | Year 2 | Year 3 | Year 4 | |
| Initial Outlay (a) | $100K | ||||
| Net cash-flows (b) | $20.00K | $30.00K | $40.00K | $50.00K | |
| Using PV factor of 10% NPV= | +$7.15K | ||||
| Simulating it : | |||||
| Using PV factor of 15% NPV= | +$0.5K | ||||
| Using PV factor of 12% NPV= | $0.00K |
To calculate the Internal Rate of Return, we can either use the interpolation method which is to take two discount rates, one rate that gives a positive NPV and another discount rate that give a negative NPV and interpolate the IRR.
Or you can use a calculator or a computer model (excel formula for IRR).
Interpretation of IRR:
If the IRR for the project is12% and the cost of capital used to finance it is lesser than 12%,then the project should be accepted.
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Earlier article was on the traditional Accounting Rate Of Return(ARR).
In this article, we look at the Payback Method which seeks to determine how long it takes for the investment project to pay back its initial capital cost.
Illustration:
Let’s say we have two project A & B, having the following initial capital cost, cash inflows and timing
Project A:
Year | Investment | Cash Savings/Inflows | Cumulative Inflows |
0 | 100,000 | ||
1 | 30,000 | 30,000 | |
2 | 40,000 | 70,000 | |
3 | 30,000 | 100,000 | |
4 |
Payback period = 3 years
Project B:
Year | Investment | Cash Savings/Inflows | Cumulative Inflows |
0 | 100,000 | ||
1 | 60,000 | 60,000 | |
2 | 40,000 | 100,000 | |
3 | 30,000 | 130,000 | |
4 |
Payback peiod=2 years
Using the payback period methodology, the analysts merely see how long or how fast the investment can be recouped.
In the aforesaid situation, we see that by investing in Project B, the company has a faster payback period of 2 years instead of Project A which takes a bit longer which is 3 years.
Like the accounting rate of return, payback method also has its advantages and disadvantages.
The advantages are:
However, its following disdvantages outweight the abovesaid advantages:
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One way of appraising capital investment is the traditional Accounting Rate of Return(ARR) Method or Accounting Return on Book Value.
In this article, there are two parts.
The first part illustrate how to compute Accounting Rate Of Return method and the next part is to discuss its advantages and disadvantages.
About Accounting Rate of Return(ARR):
Worked Example:
Let’s say we are evaluating the below said project with the following Initial Outlay/Investment and Net Cash flow ( Revenue minus Costs)
Investment:
Year 0 | Year 1 | Year 2 | Year 3 | Average | |
Gross Book Value of Investment | 100,000 | 100,000 | 100,000 | 100,000 | |
Depreciation | 20,000 | 20,000 | 20,000 | ||
Accumulated Depreciation | 20,000 | 40,000 | 60,000 | ||
Net Book Value | 100,000 | 80,000 | 60,000 | 40,000 | 70,000 |
Returns/Net “Cash flow (Revenue-Costs)
Year 1 | Year 2 | Year 3 | Average | |
Revenue(a) | 50,000 | 70,000 | 100,000 | |
Costs (b) | 20,000 | 30,000 | 40,000 | |
Cashflow (a-b) | 30,000 | 40,000 | 60,000 | |
Depreciation | 20,000 | 20,000 | 20,000 | |
Net profit | 10,000 | 20,000 | 40,000 | 23,300 |
Accounting Rate of Return
=
Average annual returns
Average annual investments
= $23,300
$70,000
= 33.3%
This Part B looks at the advantages and disadvantages of applying the Accounting Rate Of Return (ARR) method.
Append below a snapshot of the Pro’s and Con’s of ARR:
Pro’s | Con’s |
It takes all the years into account when making an investment decision, | There is no account of time value of money. It does not take into account the fact that dollars to be received in the future is not worth as much as money in the hand today. |
It’s is easy to use and is familiar concept to managers which they refer to as “ return on investment” or “ return on Capital employed. | It is purely based on accounting figures and not on cash flow. Thus it
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Having calculated the return, we still do not know whether the return is acceptable or not?
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