9. Investment decisions

All organizations have to make investment decisions through the process of acquiring, replacing or upgrading premises, equipment or vehicles, hiring new staff, investing in training, or changing systems and procedures. Such decisions must make strategic sense for the organization, but they must also make good financial sense. It is because of this that managers at all levels find themselves involved in the financial evaluation of investments, whether it be in preparing proposals or evaluating options. This chapter therefore aims to provide the understanding necessary for managers to participate in the financial evaluation of investment opportunities.

LEARNING OUTCOMES

After studying this chapter, the reader will be able to:

Assess the financial impact of an investment using traditional techniques.
Evaluate the strengths and weaknesses of the above techniques.
Demonstrate an awareness of alternative techniques.
Explain the role of financial assessment within the wider strategic assessment of investment decisions.

KEY TOPICS COVERED

Traditional investment appraisal techniques.
The strengths and weaknesses of individual appraisal techniques.
The use and abuse of investment appraisal techniques.
Financial analysis within the overall context of investment planning.
Non-financial factors in investment appraisal.
Alternative strategic approaches to investment appraisal.

MANAGEMENT ISSUES

Managers need to be able to interpret and evaluate the results of financial investment appraisal calculations, rather than perform the calculations. This chapter therefore focuses on those skills.
The apparent sophistication and precision of financial investment appraisal techniques can mask shortcomings and behavioural aspects of their application. This chapter therefore includes evaluation of frequently used techniques within a wider behavioural context.

Introduction

Investment appraisal is the process of deciding which projects or assets to invest in. In this chapter we will look at how to evaluate investments from a financial point of view and how such financial analysis fits into the overall investment decision process. Investment appraisal should always be understood within the wider context of strategic formulation and implementation. Although such matters are beyond the scope of this textbook, this chapter will look at how non-financial factors, risk levels and wider strategic concerns can impinge upon the more traditional concerns of the immediate economic return from an investment.

Investment appraisal, sometimes referred to as capital investment appraisal, is concerned with organizational decisions about investment in equipment, machinery, buildings or other long-term assets. This can include a range of types of decision such as replacement of existing assets, investing in new IT or equipment to reduce operating costs, expansion through purchasing new buildings or equipment, improving delivery service or staff training. However, the principles apply equally to investments in shares in companies, whether made by businesses or individuals. Therefore the techniques looked at in this chapter are equally relevant to both businesses and individuals who are involved in making investments.

The importance of good investment appraisal lies with the strategic and financial importance of the investments made. Investments will shape the future of the organization. Such investments often involve large resources. Wrong decisions can be costly and difficult to reverse and will have a direct impact on the organization’s ability to meet its strategic objectives.

From a financial point of view, an investment involves making a cash outlay with the aim of receiving future cash flows in return. At a basic level, assessing the financial viability of an investment involves simply comparing costs with benefits, and ensuring that the benefits outweigh the costs. However, in practice this can prove difficult, as identifying and measuring the costs and benefits from an investment can be a complex task. This chapter will address some of the problems of investment cost–benefit analysis and look at how techniques have developed in order to meet these problems.

In order to help make investment decisions, a common method of appraisal is required; one which can be applied equally to a whole spectrum of investment situations and which will enable the decision-maker to assess individual investments and compare alternative investment opportunities.

Investment appraisal – the basics

In this section we will consider the important questions which should be asked when an investment is being evaluated. Imagine that you are offered an investment opportunity as follows: ‘Invest $1,000 with me now and I promise that I will make you rich.’ Before you hand over your money, what is the information that you need in order to evaluate this investment opportunity effectively?

Firstly, you would want some clarification on how ‘rich’ the investment would make you. In other words, you want some information on the return that the investment offers.

Secondly, you would also want to know when you will become rich. You therefore need more information on the timing of returns from the investment. There would be a significant difference between receiving a return immediately and receiving the same return in 10 years’ time. This is referred to as the ‘time value of money’. This principle recognizes that the sooner you receive a return, the more valuable that return is to you.

Thirdly, you would also want some more information on the risks involved in your investment. If you are going to invest $1,000, what is the risk that the promised return never materializes (or that you lose the whole $1,000)?

Therefore, we can say that in evaluating a potential investment we need information about three key issues: risk, return, and timing.

Having established these basic principles we can now look at the techniques most frequently used in practice by businesses for investment appraisal, and examine how these techniques address the questions raised above.

Traditional evaluation techniques

There are three techniques which are in common usage in evaluating capital investment decisions:

payback period (PP);
accounting rate of return (ARR);
discounted cash flow (DCF).

The last of these techniques, discounted cash flow, can be divided into two different methods of application: net present value (NPV) and internal rate of return (IRR).

In order to examine each of these techniques we will look at how they are applied to a simple investment opportunity, as set out in Worked Example 9.1.

WORKED EXAMPLE 9.1

Soundzgud Co is a manufacturer of hifi equipment. The company is currently considering the launch of a new amplifier called the ‘Window Rattler’. Research indicates that the company can expect sales of its new amplifier as shown in Table 9.1.

Table 9.1

Year	1	2	3	4	5	6
	$’000	$’000	$’000	$’000	$’000	$’000
Revenue	600	800	800	700	500	400

The machinery needed to produce the ‘Window Rattler’ will cost $1,200,000. However, at the end of six years this machinery can still be used for other products and is expected to then have a value of $150,000. The machinery will be purchased as soon as the decision to manufacture has been approved by the board of directors.

The company accountant has forecast the production costs for the ‘Window Rattler’ (Table 9.2).

Table 9.2

Year	1	2	3	4	5	6
	$’000	$’000	$’000	$’000	$’000	$’000
Production costs	320	410	410	350	250	200

The production costs exclude depreciation, which the company normally charges on a straight-line basis. The company uses a discount rate of 15 per cent to evaluate new investments.

Expert view 9.1: Common notation conventions

Because of the importance of timing, any cash flows or profits in relation to an investment must be allocated to a particular accounting period. With the use of computer spreadsheets, an accurate analysis of timing can be made to the nearest month or even week or day. However, as all cash flows used in investment appraisal are forecasts, and therefore by their very nature estimated, it is often not possible to identify when they will occur to such a high level of accuracy. Therefore, the most common convention for investments which will run over several years is to identify cash flows by year and to assume that they will arise at the end of the year. Obviously, this may not be the actual pattern of cash flows.

A significant difference between profit and cash flow is that profit is recorded using the accruals principle. That is to say, sales and purchases are recorded when the transaction takes place rather than when any underlying payment is made. This means that, in practice, profit may be allocated to a different period from the underlying cash flow. However, for simplicity, in this example it will be assumed that cash flows occur in the same period in which accounting costs or revenues arise.

Another significant difference between profit and cash flow is depreciation. This is an accounting adjustment rather than a cash payment.

A common convention in recording the timing of cash flows or profits is to use the term t₀ to denote an item which occurs immediately, t₁ to denote an item which occurs in one year’s time, t₂ for two years’ time and so on. Hence, the cash flows forecast for the ‘Window Rattler’ can be recorded as shown in Table 9.3.

Table 9.3

Timing	Cash flow	$’000
t₀ (Immediately)	Cost of machine	(1,200)
t₁ (1 year’s time)	Net cash inflow (600–320)	280
t₂ (2 years’ time)	Net cash inflow (800–410)	390
t₃ (3 years’ time)	Net cash inflow (800–410)	390
t₄ (4 years’ time)	Net cash inflow (700–350)	350
t₅ (5 years’ time)	Net cash inflow (500–250)	250
t₆ (6 years’ time)	Net cash inflow (400–200)	200
t₆ (6 years’ time)	Residual value of machine	150

We can now go on to examine how each of the investment appraisal techniques deals with this information.

Payback period (PP)

The payback period is the length of time it takes for an initial investment to be repaid out of the net cash inflow from a project. The easiest way to calculate this is to establish the cumulative net cash-flow position at the end of each year of the investment. Applied to the example of the ‘Window Rattler’ the payback period can be calculated as shown in Table 9.4.

Table 9.4

Timing	Cash flow	$’000	Cumulative $’000
Immediately (t₀)	Cost of investment	(1,200)	(1,200)
1 year’s time (t₁)	Net cash inflow	280	(920)
2 years’ time (t₂)	Net cash inflow	390	(530)
3 years’ time (t₃)	Net cash inflow	390	(140)
4 years’ time (t₄)	Net cash inflow	350	210

There is no need to take this calculation further than four years as we can see that the initial cost of the investment is paid back sometime between three and four years. At the end of three years there is still another $140,000 to pay back, but after four years the initial cost plus a further $210,000 has been paid back. If we stick with the assumption that all cash flows arise at the end of the year, we would say that this investment has a payback period of four years. However, if we assume that the cash inflows arise evenly throughout the year, we could calculate the payback period to a fraction of year as follows:

Simply knowing that this investment would take 3.4 years to pay back does not in itself tell us whether this is a good investment. An evaluation has to be made as to whether this is an acceptable payback period. However, if two or more alternative investments are being compared, they can be ranked in terms of their payback period, with the shortest being the most attractive.

Extract 9.1: Payback period in use – Standard Life and Next

In practice, businesses which use this technique have predetermined payback periods. These tend to differ according to type of investment. For example, an investment in IT equipment may be required to pay back within two years. On the other hand, investment in a new building may be required pay back within 20 years:

Standard Life, a pensions and life assurance company, set itself a payback period of five years for any new products launched.
Next, a UK-based retailer, uses a payback period of 18 months when investing in a new clothing store. However, when the business opened its first Home and Garden store in 2011, it set a payback period of 25 months.

Evaluation of PP

Having examined how the payback period works as an investment technique, we can evaluate how well it addresses the three questions we set at the beginning of this chapter. The payback period, by its very nature, tells us something directly about timing. In doing so, it also tells us indirectly about an important aspect of risk, because a shorter payback period can be equated with a lower level of risk. However, the technique tells us very little about return other than the fact that the initial outlay is recovered. Payback period can therefore be seen as more of a risk appraisal tool than a measure of return.

In fact, in terms of addressing return, the technique has some major shortcomings. Firstly, it ignores cash flows outside of the payback period and in doing so ignores total return. Consider Worked Example 9.2 which compares two potential investments.

WORKED EXAMPLE 9.2

Table 9.5

Timing	Cash flow	Investment A: $’000	Investment B: $’000
Immediately (t₀)	Cost of investment	(600)	(600)
1 year’s time (t₁)	Net cash inflow	200	200
2 years’ time (t₂)	Net cash inflow	200	200
3 years’ time (t₃)	Net cash inflow	200	200
4 years’ time (t₄)	Net cash inflow	10	400
5 years’ time (t₅)	Net cash inflow	5	600
6 years’ time (t₆)	Net cash inflow	5	800

Both Investment A and Investment B have identical payback periods of three years and are therefore equally attractive according to the payback period technique. However, in years 4 to 6 the cash returns of Investment A fall substantially. In comparison, the cash returns of Investment B continue to rise. Looking at this full picture, Investment B is clearly a better alternative, as the same initial investment offers a much greater overall return. But this fact is not revealed by the payback period method of analysis. To take this example a step further, consider the implication of Investment A offering a $400,000 return in year 1. This would make the payback period two years. Investment A would therefore be favoured using the payback period method of evaluation, even though Investment B offers a much higher overall return. An issue to be aware of when using this technique, therefore, is that it favours short-term returns rather than highest overall returns.

A second shortcoming is that the technique ignores the timing of cash flows within a payback period. Consider Worked Example 9.3, again of two investments with identical payback periods.

WORKED EXAMPLE 9.3

Table 9.6

Timing	Cash flow	Investment A: $’000	Investment B: $’000
Immediately (t₀)	Cost of investment	(600)	(600)
1 year’s time (t₁)	Net cash inflow	500	50
2 years’ time (t₂)	Net cash inflow	50	50
3 years’ time (t₃)	Net cash inflow	50	500

Both investments take exactly three years to pay back the initial cost. However, Investment A has repaid the bulk of this initial cost by the end of the first year. There is therefore a significant difference between the two investments in that we can say Investment A is less risky. Were the investment to stop suddenly for some reason at the end of year 2, the business making Investment A would have already recovered a substantial part of the initial cost, whereas the business making Investment B would have lost most of this money.

Despite the shortcomings, payback period is an extremely popular investment appraisal technique in practice. Several surveys of businesses conducted over the past 40 years have all shown that, despite the rise in popularity of more sophisticated techniques, payback period remains the most widely used means of investment appraisal, being used by around 80 per cent of businesses. Its strength lies in its simplicity – it is not difficult to calculate or to understand. Most importantly, it appeals to a basic human level of psychology. Anyone having made a substantial investment understands that there is an initial period of anxiety concerning the risk of that investment. The point at which the investment has repaid its initial outlay is an important psychological landmark as it means that the initial capital investment has not been lost. It is because of this that payback period becomes an extremely important technique when a company has liquidity constraints or severe limitations on the availability of financing. The technique is also most useful for projects which are known to have a short life and require a quick repayment of investment.

Extract 9.2: Disney buys Star Wars

In 2012 Disney bought Lucasfilm, the company behind the Star Wars films, for US $4bn. How does this purchase price stack up in terms of return on that investment? The main value comes from the potential earning of future films. Disney has announced that it plans to release three new Star Wars films, one every three years, starting in 2015. The last three Star Wars films generated around US $1.5bn each at the box office. Such films usually cost around US $0.5bn to make and market, so that would generate Disney net cash flows of US $3bn. In addition, Lucasfilm has ongoing revenue of around US $0.9 billion per year from existing films, video games and related consumer products. There is an obvious risk in terms of the success of future films, but the last three Star Wars films were a box office success despite not being well received by many fans. These cash-flow forecasts would suggest a payback period as short as five years. Not bad for a brand that has been financially successful for the past 35 years and looks set to continue long into the future.

Accounting rate of return (ARR)

The term ‘accounting’ in accounting rate of return refers to the basis of calculation of this technique, which is accounting profits. Unlike the other techniques examined in this chapter which all use cash flow, ARR is calculated on the accruals basis, ie using profit.

The ARR is sometimes referred to by other names. In the United States it is more widely called return on investment (ROI). Other names include average rate of return, book rate of return or unadjusted rate of return. It is also sometimes called return on capital employed (ROCE). However, as will be seen below, this name is more appropriately applied to divisional or overall company performance, rather than the tool for investment appraisal. This multitude of names reflects both the wide usage of the technique and the fact that there is a range of definitions as to its calculation.

Although there are different ways of calculating ARR, which will be discussed below, we will concentrate on the most commonly applied calculation. This takes the ‘return’ on an investment as being the average accounting profit after depreciation and expressing this as a percentage of the average investment over the life of the project:

Applying this formula to our investment scenario in Worked Example 9.1, the average annual profit can be calculated by dividing the total profit for the investment by the number of years over which this profit is earned.

The total profit before deducting depreciation is $1,860,000 ($280,000 + $390,000 + $390,000 + $350,000 + $250,000 + $200,000).

The total depreciation can be calculated as the initial cost less the residual value of the investment = $1,200,000 – $150,000 = $1,050,000.

Because the company charges depreciation on a straight-line basis, the average investment will be the value halfway between the initial cost and the residual value:

Once calculated, this ARR of 20 per cent can be compared with a predetermined minimum acceptable return for the company. For example, if Soundzgud has a predetermined requirement of a return on investments of 15 per cent, the above return of 20 per cent would be acceptable.

Evaluation of ARR

Unlike payback period (and the discounted cash-flow techniques we will look at later in the chapter), the ARR evaluates investments based upon profits. The other techniques use cash flows. There are both advantages and disadvantages to this use of profit.

The main advantage of ARR is that it calculates the performance of an investment in terms of profit returns, which is in line with the most often reported figure for overall company performance. ARR provides a measure which is directly comparable with ROCE, which is the most common measurement of the financial performance of a business as a whole.

ROCE is measured as:

It can therefore be seen that there is direct comparison between the formula for ARR and that for ROCE. They are both measuring the same thing – the level of profit in relation to the capital invested in order to earn that profit: ARR measures this at the level of the individual investment; ROCE measures it at the divisional or company level.

It makes sense to use a measure for evaluating new investments which reflects the way the performance of the whole business will be evaluated. By comparing the ARR of a new investment with the existing ROCE of the whole business, managers are able to assess the potential impact of that new investment on the financial performance of the business as a whole. If a new investment has an ARR which is lower than the existing ROCE, that investment will reduce the future ROCE of the business. On the other hand, a new investment with an ARR greater than the existing ROCE will increase that ROCE in the future.

Despite the advantages outlined above, ARR suffers from some major deficiencies which have caused the technique to be criticized by many academic commentators. However, it is still widely used in practice, so you need to be aware of these deficiencies and their implications:

ARR uses the accruals concept, that is to say, it is calculated from profit rather than the cash flow. Profit is far more judgemental and therefore easily manipulated than cash flow. For example, profits from an investment will vary with different methods of stock valuation and depreciation calculation. This means that it is more difficult to obtain an objective measure of performance. If ARR is being used to make comparisons between different organizations, problems will arise in comparing the figures.

ARR is a relative measure: it measures profit returns in relation to the amount invested. This makes it possible to compare the profitability of investments of different sizes, but it means that if ARR is used to choose between two or more projects, a small project may have a higher ARR than a larger project whilst giving a much smaller absolute profit.

There is no universally accepted basis of calculating the figures used for either the profit from an investment or the capital invested to earn that profit. This means that, in practice, erroneous comparisons may be made between investments because one is not comparing like with like. One major problem is that there is disagreement over whether the ARR calculation should use average capital invested (as shown in the example above) or initial investment. The argument for using the initial investment is that this is the cost of the investment and therefore reflects the return required to recover that cost. The more widely accepted average capital invested method argues that the ARR calculation should take into account the fact that the initial cost is written off over the life of the investment, and that an average return therefore needs to reflect the average value of the capital investment. Neither method is wrong; they simply reflect different principles.

The technique ignores the timing of profits, as the averaging used in the calculation of ARR removes all information about timing of receipts and payments. Consider Worked Example 9.4 in which three different investments each lasts four years:

WORKED EXAMPLE 9.4

Table 9.7

Profits ($’000)	Investment A	Investment B	Investment C
Year 1	850	50	250
Year 2	50	50	250
Year 3	50	50	250
Year 4	50	850	250

All three investments offer an average annual profit of $250,000. However, there are significant differences in both the evenness and the timing of this profit. This information, which may be important in an investment decision, is lost in the ARR calculation through the process of averaging. ARR is therefore blind to the time value of money.

Another problem arises because of this averaging process. It renders the technique unsuitable for comparing investments of different lengths. If an investment offers long-term but diminishing profits, then as each year of a lower profit is added to the calculation the average profit will be pulled downwards. Consider Worked Example 9.5 in which two investments have the same initial cost of $1 million with no residual value. However, Investment A has a life of only three years whereas Investment B has a life of six years:

WORKED EXAMPLE 9.5

Table 9.8

Profits ($’000)	Investment A	Investment B
Year 1	300	300
Year 2	300	300
Year 3	300	300
Year 4	–	200
Year 5	–	150
Year 6	–	100

For the first three years both investments offer the same level of profits. However, Investment B continues to deliver profit for a further three years, albeit at a lower level. Investment B offers a total profit return of $1,350,000 from an initial investment of $1 million, whereas investment A offers a total profit return of only $900,000 from the same initial investment.

However, when we calculate the ARR of each investment, Investment A appears to be the more attractive simply because the average annual profit is higher:

Discounted cash flows and the time value of money

The final two investment appraisal techniques we will examine in this section both involve the use of discounted cash flows. Discounting a cash flow involves making adjustments for the time value of money, that is to say, to reflect the fact that when you receive money has an impact upon its value to you.

Here is a simple example to illustrate this principle: Would you prefer to receive $100 now or $100 in two years’ time? I would imagine that you would answer that you would prefer to receive the $100 now, for a number of reasons:

There is always the risk that you will not actually receive the $100 in two years’ time.

The effect of inflation means that you can buy more with your $100 now than you will be able to in two years’ time. Hence it is more valuable to you now.

You could take the $100 now and invest it for two years, after which you would have more than $100.

We will look at risk and inflation later in this chapter, but at this point we can examine the issue of earning interest in more detail. In the example above, deciding between $100 now or $100 in two years’ time was relatively easy. However, what if I offered you a choice of $100 now or $108 in two years’ time? You need some means of comparing the two amounts to decide which is the more attractive. One way in which you could do this is to ask: ‘What would $100 received now be worth if I invested it for two years?’

Compounding and discounting

Let us assume that you can invest your $100 received now at an interest rate of 5 per cent. At the end of one year you will have $105 ($100 × 1.05). At this point, the principle of compound interest starts to apply, because in the second year you will earn interest not only upon your original $100 but also upon the $5 interest you earned in the first year. Hence, at the end of two years you will have $110.25 (($100 × 1.05) × 1.05).

Because the formula calculating this is $100 × 1.05 × 1.05 = $100 × 1.05², we can generalize this as:

This technique gives you a way of comparing the $100 offered now with the $108 offered in two years’ time. You can calculate that if you take the $100 now and invest it for two years at 5 per cent, you will end up with $110.25. You would therefore be better off taking the $100 now rather than the $108 in two years’ time.

This technique works well for a simple investment scenario such as that given above. However, it is not so useful if the investment is a little more complex.

What if you were offered the alternative of $100 now or $55 in one year’s time and a further $55 in two years’ time? In this case you cannot use the compounding technique shown above, because there is no single time in the future to which you can compound the $100 received now. We therefore need to modify the technique.

The one point in time which we can always use consistently is now (the present moment). So rather than asking the question ‘what will $100 received now be worth at some point in the future?’, we ask ‘what would the money received in the future be worth if received now?’ By asking the question this way we can compare monies received at several different points of time in the future.

Let us go back to the choice between $100 received now and $108 received in two years’ time. Rather than compounding the $100 forward, we discount the $108 back to today’s date by asking the question: ‘What would I need to receive now to have the equivalent of $108 in two years’ time?’ Another way of looking at this is to ask: ‘If I can earn interest at 5 per cent per year, how much do I need to invest now in order to end up with $108 after two years?’ We can calculate this by using the formula which we established above:

A = P × (1 + r)ⁿ

We used this formula before to calculate the value of A (the amount received in the future) when we already have the value of P (the amount invested now). We simply need to rearrange the formula to start with A, the amount receivable in the future ($108), and calculate the value of P:

This means that if we wanted to receive $108 in two years’ time we would have to invest $97.96 now. In terms of the time value of money, receiving $108 in two years’ time is the equivalent of receiving $97.96 now. We can compare the two alternatives: receive $100 now or receive an amount in two years’ time which is the equivalent of receiving $97.96 now. We end up with the same decision as we did before – it is better to take the $100 now.

What of the second scenario in which you were offered the alternative of $100 now or $55 received at the end of one year and a further $55 received at the end of two years? The calculation is a little more complex, but we can evaluate these alternatives using this new discounting technique. We do this by taking each of the future amounts and discounting them back to their present value and then adding them together as follows:

Therefore, receiving $55 in one year’s time plus $55 in two years’ time is the equivalent of receiving $52.38 + $49.89 = $102.27 now. We are now able to evaluate this choice. In this case we would be better off taking the two future amounts as their present value is more than the $100 offered now. (In fact, we can measure precisely that we would be $2.27 better off in today’s terms by taking the future amounts: $102.27 – $100 = $2.27).

Discount tables

The fraction by which we multiply the future cash flow A in order to calculate its present value P is known as the discount factor. This, as was shown above, is calculated using the following formula:

Because we use the same formula every time to calculate a discount factor, a standard set of values can be set out in a table which provides the discount factor for common discount rates and time periods. A discount factor table is available in Appendix D.

Net present value (NPV)

The NPV technique uses the principle of discounting cash flows explained above. The NPV of an investment is the sum of the present values of all cash flows which arise as a result of undertaking that investment.

The present value (P) of a single sum, A, receivable in n years’ time, given an interest rate (discount rate) of r, is given by:

Let us now see how this technique works when applied to the Soundzgud Co investment in Worked Example 9.1. The discount rate we need to apply to the cash flow from the project is 15 per cent. The relevant discount factors have been extracted from Appendix D. We can present the NPV calculation as shown in Table 9.9.

Table 9.9

	Cash flow	Discount factor	Present value
	$	(15%)	$
t₀ (Immediately)	(1,200,000)	1.000	(1,200,000)
t₁ (1 year’s time)	280,000	0.870	243,600
t₂ (2 years’ time)	390,000	0.756	294,840
t₃ (3 years’ time)	390,000	0.658	256,620
t₄ (4 years’ time)	350,000	0.572	200,200
t₅ (5 years’ time)	250,000	0.497	124,250
t₆ (6 years’ time)	200,000	0.432	86,400
t₆ (6 years’ time)	150,000	0.432	64,800
Net present value			$70,710

From this calculation it can be seen that the NPV of this investment is $70,710. This can be interpreted as meaning that the company will be $70,710 better off, in today’s terms, by undertaking this investment.

There is therefore a simple rule for interpreting NPV calculations: If the NPV is positive, the company will increase its wealth by undertaking the investment, which is therefore financially viable; if the NPV is negative, the company would decrease its wealth by undertaking investment and the investment should therefore be rejected.

The NPV technique can be seen as a more sophisticated means of investment appraisal than the payback period and the ARR. Unlike the payback period, NPV takes account of the entire cash flow of the project; unlike ARR, NPV takes account of the timing of earnings from an investment. The further into the future a cash flow arises, the more it is discounted. This reflects the increased risk and uncertainty of cash flows as they lie further into the future.

Not only is NPV more sophisticated in the way that it takes account of timing, risk, and return, but it is also a technique which is capable of incorporating more sophisticated and subtle analysis of investments. We will see this as we look at more complex investment scenarios later in the chapter.

Internal rate of return (IRR)

Internal rate of return is a second discounted cash-flow technique which works on the same mathematical principles as NPV, but uses discounting to give an answer in a slightly different format.

In the NPV calculation above, we discounted the cash flow from the Soundzgud investment at 15 per cent to produce a positive NPV of $70,710. The implication of this positive NPV is that the actual return of the investment is greater than 15 per cent. The discount rate which we apply in calculating the NPV represents the minimum acceptable return. A positive NPV means that this minimum return has been exceeded and this is why investments with a positive NPV should be accepted.

Another way of using the DCF technique would be to calculate the actual discounted cash-flow return of the investment and compare that to our minimum acceptable return of 15 per cent. This is known as the internal rate of return, as it is the rate of return ‘internal’ to, ie within, the project.

In practice, the IRR will be the discount rate which gives an NPV of zero. With a computerized spreadsheet, calculating this discount rate is relatively straightforward. However, if a computer is not available, the IRR can be estimated as demonstrated below.

Returning to the Soundzgud investment in Worked Example 9.1, the NPV at 15 per cent was a positive value of $70,710. This means that the IRR of the investment must be greater than 15 per cent. We can therefore choose a discount rate greater than 15 per cent and recalculate the NPV to see if we are closer to the IRR. (Remember, the exact IRR would give an NPV of zero.) Let us discount the project again using a discount rate of 20 per cent (Table 9.10).

Table 9.10

Timing	Cash flow	Discount factor	Present value
	$	(20%)	$
t₀ (Immediately)	(1,200,000)	1.000	(1,200,000)
t₁ (1 year’s time)	280,000	0.833	233,240
t₂ (2 years’ time)	390,000	0.694	270,660
t₃ (3 years’ time)	390,000	0.579	225,810
t₄ (4 years’ time)	350,000	0.482	168,700
t₅ (5 years’ time)	250,000	0.402	100,500
t₆ (6 years’ time)	200,000	0.335	67,000
t₆ (6 years’ time)	150,000	0.335	50,250
Net present value			$(83,840)

This time we get a negative NPV of –$83,840. This means that the IRR must lie somewhere between 15 and 20 per cent. We can establish the IRR more accurately using a mathematical technique called linear interpolation. This is done by applying the formula:

So in this case we can say that the investment offers an internal rate of return of 17.3 per cent. We can then compare this to an acceptable minimum level of return in the same way as we did with the ARR technique.

Extract 9.3: EDF – IRR in the energy industry

Investment in energy infrastructure in the UK involves a delicate partnership between the government and the private sector. Adequate returns are critical to attracting suitable private-sector investment. The government is seeking to increase investment in low-carbon energy infrastructure, but this can represent a high risk to investors who consequently require high returns. Investors in gas-fired power plants typically expect an IRR of around 10 per cent, whereas investors in wind generation expect an IRR of 10 to 13 per cent.

The government can reduce the returns demanded by reducing the risk. In 2013 the UK government struck a deal with EDF Energy, the French energy company, to subsidize the building of a new nuclear power plant at Hinkley Point in Somerset. The plant has an estimated build cost of £16bn, which is too high to represent a viable investment. The government is therefore offering various incentives, including guaranteeing EDF’s income in order to create an IRR of 10 per cent from the plant. Industry experts estimate that this will add up to a subsidy of £7 per household per year. The complexity of this deal underscores the importance of IRR for investors. Without an adequate return on the investment, no new power plants would be built and the UK would risk facing power shortages.

Evaluation of IRR

The IRR is used in the same way as ARR, by comparing with a predetermined acceptable value. However, the IRR uses discounted cash flows rather than average profits, and therefore has all the advantages we identified when looking at the NPV technique: it takes account of risk, timing and returns.

However, one major drawback of the IRR technique is that it will not work with investments which have what are known as ‘non-conventional’ cash flows. A conventional investment cash flow is one which involves an initial cash outflow followed by a series of cash inflows. With some investments, net cash flows can flow both inward and outward throughout the life of the project. For example, investment in a nuclear power plant may involve initial cash outflows followed by many years of cash inflows and then substantial cash outflows as the power plant is decommissioned at the end of its life. The IRR technique cannot cope with cash flows such as this, as mathematically it will produce more than one value. It is possible to modify the IRR technique to work around this problem, but such calculations are beyond the scope of an introductory text such as this.

Although DCF techniques are more sophisticated in integrating the factors of risk, timing and returns, they do have some drawbacks which have led to criticism. The process of discounting cash flows inevitably leads to a favouring of investments which offer returns in the shorter term. It has been suggested that this leads to short-termism and a reluctance to make investments which offer strategic benefits which may be more long-term and more difficult to quantify. Also, the techniques have been criticized as being inadequate for evaluating new technology investments as they are unable to evaluate non-quantifiable issues. We will look at some methods for addressing these problems later in the chapter.

Exercises: now attempt Exercise 9.1 on page 363

Incorporating real-world complexities into investment appraisal

So far we have examined the main investment appraisal techniques using a relatively straightforward example. However, in the real world, investment appraisal decisions will be more complex and need to take into account issues such as inflation and the impact of taxation. In this section we will examine some of these real-world complexities and look at how they can be incorporated into our calculations.

Establishing an appropriate discount rate

The discount rate used in an NPV calculation represents the minimum acceptable rate of return for the investor. In practice, a wide variety of methods can be used to determine appropriate discount rates. Most organizations establish a discount rate based upon either the weighted average cost of capital (WACC) or the capital asset pricing model (CAPM). Explanation of these techniques is beyond the scope of this textbook. However, whatever method is used in practice, it is based upon certain principles. The rate of return from an investment should be sufficient to cover the cost of financing that investment and should incorporate an assessment of the risk. In simple terms, the more risky an investment is perceived to be, the higher the discount rate used to evaluate it. Hence one important way in which risk assessment is incorporated into investment appraisal is through adjustment of the discount rate used in NPV calculations.

Deciding what to count: relevant cash flows

One of the most common mistakes in investment appraisal in practice involves using the wrong figures. This can mean including costs which should not be counted, or omitting costs or revenues which should be included. These mistakes can lead to inappropriate investment decisions, with disastrous consequences for future business operations.

An important principle in decision making, therefore, is that only those costs or revenues which are affected by the decision should be considered. A frequent error is to include costs which will be incurred anyway, even if the investment were not made. These may include, for example, the costs of employees working on a project, but who would be paid anyway, regardless of whether or not the project goes ahead. In a similar way, factory costs, administration and head office costs which will not change as a result of the project should not be included.

Likewise, costs already incurred, even if they relate to the investment, such as market research or product development already completed, should not be included in an investment appraisal calculation. This is because these costs, having already been incurred, cannot change as a result of making the investment.

Therefore, as a simple rule of thumb, you should include in investment appraisal calculations only those costs or revenues which will change as a result of undertaking the investment (see Worked Example 9.6 below).

Opportunity costs

Opportunity costs are a category of costs used only in decision making. They can be extremely important in assessing the true financial impact of an investment. An opportunity cost can be defined as the cost of an alternative that must be forgone in order to pursue a certain action. Opportunity costs arise from the recognition that committing resources to one project means that they cannot be used on other projects. This may mean that there is a cost to the business in terms of the lost ‘opportunity’ of using that resource elsewhere. For example, using a production facility to make one product means that that facility cannot be used to make a different product, even though the alternative may be extremely profitable. This example may be obvious, but some opportunity costs are less obvious. For example, opening a new store may draw business away from existing stores in the same area, reducing their profits.

By incorporating opportunity costs into investment appraisal calculations, a business is able to quantify the loss of other potentially profitable opportunities and thereby ensure that the most profitable course of action is taken. To ensure that this is the case, opportunity cost is always measured in terms of lost contribution from the use of a particular resource.

Expert view 9.2: Contribution

Contribution = Revenue – Variable (direct) costs

WORKED EXAMPLE 9.6 Relevant costs and opportunity costs

Zebra Co is a paint manufacturer that is planning to launch a new range of fast-drying paints. The directors of Zebra Co have asked you to help evaluate the financial viability of the new paint range. Which of the following amounts would you include in an NPV calculation?

A A proportion of head office administrative costs calculated at $18,000 per year.

B Depreciation on the new paint manufacturing plant purchased for the project.

C Salaries of 10 new workers hired to operate the new plant.

D Financing costs of $25,000 per year on the loan to purchase the new plant in (B) above.

E The salary of $35,000 per year of the manager running the new plant. This manager ran one of the other manufacturing plants and has been transferred to this job because of his experience. In his absence, the other plant is being run by a new manager hired as a replacement for the duration of this project. The new manager has a salary of $28,000 per year.

Answers

A Head office costs will be incurred regardless of whether or not the new range of paints is launched. These costs should therefore not be included in an NPV calculation as they are not relevant.

B Depreciation is not a cash flow. This cost should therefore not be included.

C The salaries of new workers are a relevant cost and should therefore be included in the NPV calculation.

D Financing costs should not be included in the cash flows to be discounted. The cost of financing the investment will be incorporated into the discount rate used to evaluate the investment.

E This is an example of an opportunity cost. The additional cost to the business of using the experienced manager on this project is the $28,000 it costs to replace him in his old job. The amount which should be included in the NPV calculation is therefore $28,000 per year, rather than $35,000 per year.

Taxation

Tax payments can have a significant impact on investment cash flows and should therefore be taken into account. There are four aspects of taxation which are relevant to investment appraisal:

Income tax paid on profits from an investment will represent a cash outflow for a business and therefore needs to be incorporated into the NPV calculation. Because of the importance of timing, when tax is paid can make a difference.
Interest on any debt financing is an allowable expense against income tax. The method of financing an investment will therefore impact upon tax cash flows.
Any tax losses may give rise to tax relief on other profits which can reduce the amount of taxation payable.
Capital allowances are the income tax equivalent of depreciation. They provide tax relief on the investment in assets which will reduce the cash outflows for income tax. For projects involving large investments in buildings, plant or equipment, capital allowances can be significant and can have a major impact upon the cash flows of the investment.

Because these aspects of taxation can have a significant impact upon the cash flows from an investment, it is important to ensure that taxation is always considered and incorporated into investment appraisal calculations.

Inflation

Inflation decreases the purchasing power of future cash inflows, making them worth less. Therefore inflation can create distortions when attempting to assess the time value of money and in calculating returns from investments. For example, a rate of return of 12 per cent could be reduced to 8 per cent in real terms after taking inflation into account. It is therefore important to incorporate the impact of inflation into the return on investments and to be clear whether a quoted rate of return includes or excludes inflation.

To avoid this confusion, different terms are used. If an interest rate includes the effect of inflation, it is referred to as the ‘money rate’. Just to add the potential for confusion, this is sometimes also known as the ‘nominal’ or ‘market’ rate. On the other hand, ‘real’ interest rates are stated after adjusting to remove inflation. The adjustment is done as follows:

(1 + real rate of interest) × (1 + rate of inflation) = (1 + money rate of interest)

Note that the real rate is multiplied by inflation, not added, to give the money rate.

WORKED EXAMPLE 9.7 Adjusting for inflation

a The real rate of return which a business requires from its investments is 12 per cent and inflation is currently 4 per cent. What is the money rate of return which the business needs to apply for investment appraisal?

Answer: The money rate of return = 16.5 per cent (1.12 × 1.04 = 1.165).

b A business experiences a money rate of return of 18 per cent on an investment. Over that same period inflation was 5 per cent. What is the real rate of return on the investment?

Answer: The real rate of return = 12.4 per cent (1.18 ÷ 1.05 = 1.124).

Dealing with inflation in investment appraisal calculations

There are two ways in which the impact of inflation can be incorporated into investment appraisal calculations:

Money method: the first method is to use ‘money’ cash flows (ie those cash flows which include inflation) and to discount these using the ‘money’ discount rate (ie the discount rate which incorporates the effect of inflation).

Real method: the second method is to use cash flows which exclude the impact of inflation and to apply the ‘real’ discount rate.

Which of these techniques is used in practice will depend upon how the cash-flow forecast for an investment has been compiled. If the cash-flow forecast is in ‘today’s terms’, without consideration of the impact of inflation, it is easier to use the real method. On the other hand, if cash-flow forecasts have been compiled looking at actual amounts payable or receivable in the future (and therefore incorporating inflation), the money method should be used.

WORKED EXAMPLE 9.8 Dealing with inflation

A company is considering investing $100,000 in a project which will give returns of $50,000 in current terms for three years. The money rate of return required by the company is 14 per cent and inflation is currently 4.6 per cent. What is the NPV?

Money method

Table 9.11

Year	Real cash flow	Money cash flow	Money discount factor	Present value
	$	(inflated by 4.6%)	@14%	$
0	(100,000)	(100,000)	1.000	(100,000)
1	50,000	52,300	0.877	45,867
2	50,000	54,706	0.769	42,069
3	50,000	57,222	0.675	38,625
Net present value				26,561*

Real method

Table 9.12

Year	Real cash flow $	Real discount factor @9%	Present value $
0	(100,000)	1.000	(100,000)
1	50,000	0.917	45,850
2	50,000	0.842	42,100
3	50,000	0.772	38,600
Net present value			26,550*

Real discount rate = 9 per cent (1.14 ÷ 1.046 = 1.09)

The small difference of $11 between these two calculations (Tables 9.11 and 9.12) is due simply to rounding.

Exercises: now attempt Exercise 9.2 on page 364

Annuities

If the level of cash flow from an investment is the same from year to year, it is referred to as an annuity. If this is the case, there is an easier way of calculating the NPV by using annuity tables. Annuity tables show the present value of $1 received every year, starting one year from now and going on for n years. A set of annuity tables is available in Appendix E.

WORKED EXAMPLE 9.9 Annuity

A company is considering investing in a project which will cost $10,000 and will yield cash inflows of $3,000 per year for five years. No scrap value is expected at the end of the project and the company uses a discount rate of 12 per cent to evaluate investments. Should the investment be accepted?

Answer:

Table 9.13

Year	Cash flow $	Discount factor	Present value $
t₀	(10,000)	1.000	(10,000)
t₁–t₅	3000	3.605	10,815
NPV			815

As the investment gives a positive NPV of $815, it should be accepted.

Capital rationing: the profitability index

Capital rationing refers to a situation in which there is a limited supply of capital to finance investment projects. In this situation, a company cannot accept all projects with positive NPVs if the costs of implementation will exceed the supply of capital. The company will therefore need to choose between alternative investments.

In practice, capital rationing arises for one of two reasons:

Hard rationing: capital markets will always supply a limited amount of capital. A company therefore may not be able to raise sufficient capital to finance all available projects.

Soft rationing: the company may have sufficient funds available but has chosen to restrict its capital investment for strategic reasons.

When faced with a situation of capital rationing a company should allocate available capital so as to maximize returns on the capital invested. Individual investment proposals should therefore be considered in terms of their rate of return (ie NPV divided by capital required). This ratio is sometimes known as the profitability index:

WORKED EXAMPLE 9.10 Capital rationing

A company has $10 million available to fund new projects in the current year. It has identified five potential investments and calculated the NPV on each investment as shown in Table 9.14.

Table 9.14

Investment	NPV	Capital required
A	$2m	$4m
B	$1m	$3m
C	$0.4m	$0.5m
D	$0.5m	$0.75m
E	$1.6m	$4m
Total		$12.25m

The company cannot undertake all five projects because this would require a total capital commitment of $12.25 million. In order to choose where to invest the $10 million available, the company will rank the proposals according to their rate of return, ie the ratio of NPV/Capital required (Table 9.15).

Table 9.15

Investment	NPV/Capital required	Ranking
A	$2m/$4m = 50%	3rd
B	$1m/$3m = 33%	5th
C	$0.4m/$0.5m = 80%	1st
D	$0.5m/$0.75m = 67%	2nd
E	$1.6m/$4m = 40%	4th

Based upon this ranking the company would invest in projects C, D, A and E in that order of preference. This would use a total capital of $9.25 million. Although this leaves $0.75 million unused, it is unlikely that project B could be subdivided such that 0.75/3.0 or 25 per cent of the project could be undertaken.

Replacement decisions

All of the investment scenarios we have looked at so far have involved investing in new assets. However, in reality, many investment decisions involve replacing existing assets. An important decision for a company is how long to retain an asset such as machinery or a company vehicle before replacing it. It is possible to use NPV calculations to determine the optimum time at which to replace an asset.

When using NPV for replacement decisions the technique is modified slightly. Firstly, the NPV is calculated in the normal way, and then the figure is adjusted to determine the ‘annualized NPV’. The company should then replace an asset at the point when the annualized NPV is maximized.

WORKED EXAMPLE 9.11 Replacement decisions

A company purchases a machine for $15,000. The machine can be used for up to three years before it will be replaced by an identical machine which will be used in the same production process. The following figures have been estimated (Table 9.16).

Table 9.16

Year	1	2	3
Net revenue $	9,000	7,500	4,500
Scrap value $	6,000	4,500	1,500

The company uses a discount rate of 10 per cent for project appraisal. Should the machine be replaced after one, two or three years?

Answer

If the machine is replaced at the end of year 1, the NPV will be as shown in Table 9.17.

Table 9.17

Year	t₀	t₁	NPV
Cost of machine	(15,000)
Net revenues		9,000
Scrap value		6,000
Total	(15,000)	15,000
Discount factor	1	0.909
Present value	(15,000)	13,635	(1,365)

If the machine is replaced at the end of year 2, the NPV will be as shown in Table 9.18.

Table 9.18

Year	t₀	t₁	t₂	NPV
Cost of machine	(15,000)
Net revenues		9,000	7,500
Scrap value			4,500
Total	(15,000)	9,000	12,000
Discount factor	1	0.909	0.826
Present value	(15,000)	8,181	9,912	3,093

If the machine is replaced at the end of year 3, the NPV will be as shown in Table 9.19.

Table 9.19

Year	t₀	t₁	t₂	t₃	NPV
Cost of machine	(15,000)
Net revenues		9,000	7,500	4,500
Scrap value				1,500
Total	(15,000)	9,000	7,500	6,000
Discount factor	1	0.909	0.826	0.751
Present value	(15,000)	8,181	6,195	4,506	3,882

Each of the NPVs is then ‘annualized’ by dividing it by the annuity factor for the number of years the investment runs:

Replacement after two years gives the highest annualized NPV. This is therefore the replacement strategy which the company should follow.

Investment appraisal within context

So far in this chapter we have looked at the main techniques of investment appraisal and how they can be applied to different investment decisions. We will now look at some of the practical considerations of investment appraisal and some of the problems involved in applying these techniques in practice.

There are a number of problems to be found in the way these investment appraisal techniques are actually used in practice. We will focus on three main aspects of practice:

Firstly, the techniques we have examined have a very narrow focus on tangible factors which can be quantified financially. In practice, many investment decisions can involve factors which are difficult to quantify or which are intangible, for example investing in a new computer system in order to improve customer service, or investment in research and development for new product features.

Secondly, the highly computational nature of the techniques, particularly NPV, means that, in practice, managers can get lost in the details of the calculations and lose sight of the fact that they are based upon forecasts which may not be accurate and which in all likelihood will not actually work out.

Finally, the narrow focus of traditional investment appraisal techniques (typified by the concept of relevant cash flows) means that they can fail to capture the richness of investment decisions within the context of a wider organizational strategy. In reality, managers will not just invest for immediate financial return, but also for wider strategic reasons such as increasing operational flexibility, gaining competitive advantage or providing more strategic options in the future. Furthermore, within today’s business context, managers must consider more than just immediate financial returns to the business’s owners; the interests and requirements of other stakeholders such as employees, customers, suppliers, wider society and the environment can be equally important in investment decisions.

Integrating qualitative factors

One of the problems with traditional investment appraisal is that it tends to lead to an analysis of tangible financial issues in isolation from other important elements of the investment decision. When qualitative considerations are brought into an appraisal, the exercise becomes more complex, even if all the elements being considered are still tangible.

Let us take the example of a company that is investing in a new computerized customer management system (CMS). This new CMS will be integrated into the existing IT-based financial system and will be available in all offices through a new computer network. When doing a financial investment appraisal, there are a number of questions which may be difficult to answer:

What tangible costs should be included? The tangible costs of new networks and other computer hardware can easily be identified. However, what is not so easy to establish is the proportion of these costs which should be allocated to the CMS investment. The network will be of benefit to all departments and all systems, and any new computers or workstations will be used for a number of other functions.

How should intangible costs be measured? Some of the costs of implementing the new CMS system will be intangible and difficult to measure. For example, management time spent on developing and reviewing the new system will be a distraction from other activities; there may be disruption to existing work as a new system is implemented; staff learning to use a new system will be slower and less productive. In such cases it may be possible to record and measure the amount of time spent on the project, but it is not so easy to record and measure the impact which this has on other activities and productivity levels.

Diminishing returns from benefits. If the rationale for implementing the new CMS is to improve customer services, then how far should this go? More and more features could be added to the CMS at an ever-increasing cost. How many of these features should be adapted? In a similar manner, increased processing power will provide information faster. It may be possible to identify that there is a clear advantage in obtaining information in two hours rather than two days. But would it be better to obtain that information in two minutes, or even in two seconds?

How should intangible benefits be measured? The problem with implementing any new investment (particularly an IT investment) aimed at improving the availability of information or quality of service is that the costs are usually tangible and easily identified, whereas the benefits are intangible. Traditional NPV calculations are not able to capture such intangibles, which means that any investment appraisal will inevitably result in a negative NPV. In many cases, the identification of costs is much easier than the identification of benefits. This is particularly the case where the benefits sought from an investment are intangible. There are therefore three options available in this case:
1 Ignore the benefits: the traditional approach is to ignore intangibles and focus only on that which can be measured in financial terms. Unfortunately, this could result in negative NPVs and the rejection of investments, simply because the benefits are not immediately financially quantifiable.

2 Quantify the benefits: a common approach is to attempt to quantify the benefits so that they can be incorporated into a traditional investment appraisal calculation. Although this may work in some cases, it may be extremely difficult to quantify some benefits or it may result in a loss of richness of information about the benefits of investment.

3 Change the approach: the balanced scorecard. A third alternative is to move away from a purely financial analysis to one which incorporates non-financial benefits. This approach tries to integrate qualitative and quantitative dimensions of evaluation within one exercise and can be termed a balanced scorecard approach. To use such a balanced scorecard approach in investment appraisal requires the decision-maker to weigh up the various quantitative and qualitative aspects of the investment and to give a ‘score’ to each aspect so that each investment can be given an overall score, which allows comparison between alternatives.

WORKED EXAMPLE 9.12 Balanced scorecard approach

Investment appraisal of new customer management system:

Financial benefits:

NPV $x.

Non-financial benefits:

x per cent of users happy with quality;
x per cent of users happy with scope;
x hours saved per month.

Exercises: now attempt Exercise 9.3 on page 365

Addressing risk: the variability in outcomes

In investment appraisal, risk is about the variability of outcomes. When we talk about investment risk we mean that the actual outcome may not be as we expect. In all the examples that we have looked at so far, calculations have been based upon one ‘best guess’ set of outcomes. Unfortunately, in reality, ‘best guess’ will hardly ever be the actual outcome. Therefore, one way of further incorporating risk assessment into investment appraisal is to analyse the range of possible outcomes. There are three main ways of doing this: sensitivity analysis; scenario analysis; and probability analysis.

Sensitivity analysis

Sensitivity analysis is a simple but powerful technique which is used extensively in practice. It examines the impact on the project return of changes in individual variables such as the investment cost, the level of cash flows and the life of the investment. The technique is applied by adjusting each major variable in an NPV calculation until the NPV equals zero (ie the point at which the investment is no longer financially viable). This gives the decision-maker an indication of how much of a change can be tolerated in each variable. If an NPV of zero is arrived at with a relatively small change in a variable, the investment is very sensitive to the value of that variable. Sensitivity analysis makes it easier to identify weaknesses in forecasts. It is an extremely good way of identifying key factors that will need careful monitoring once the project has commenced. It could also be used to evaluate whether further action should be taken to minimize risk, for example interest-rate hedging or the use of currency derivatives to manage exchange-rate risks.

Scenario analysis

Whereas sensitivity analysis is useful in isolating and identifying changes in individual variables, it is not realistic in its presumptions. In reality, it is more likely that several or all variables will change at the same time, depending upon the circumstances. Scenario analysis addresses this by predicting how multiple variables will change under different conditions, for example under improved economic conditions, or if an economic downturn occurs. It is normal for this type of financial modelling to be done using computer spreadsheets.

Probabilities and expected values

Sensitivity analysis and scenario analysis introduce the idea of using a range of different forecasts rather than a single calculation. However, they can make decision making more difficult because they give no indication of the likelihood that each of a range of different outcomes may occur. A second problem is that a range of different scenarios will give a range of different NPV values, some of which may be negative. Does that mean the investment should not be made? It is no longer possible to use the simple rule that a positive NPV means a financially viable investment.

WORKED EXAMPLE 9.13 Probability analysis

A method to overcome these problems is used by some investment analysts. This involves identifying a range of different outcomes and attaching a probability to each outcome. These probabilities can be used to calculate a weighted average of the NPVs of each different scenario as shown in Table 9.20.

Table 9.20

Scenario	NPV $	Probability	NPV × Prob
A	(100,000)	0.2	(20,000)
B	200,000	0.3	60,000
C	300,000	0.4	120,000
D	500,000	0.1	50,000
ENPV = (NPV × Prob) =			210,000

This weighted average of $210,000 is known as the expected net present value (ENPV). It offers the advantage of once more providing a single figure which can be used to evaluate the investment. If the ENPV is positive, the investment is financially viable. However, care should be taken in using this technique as the ENPV does not reflect the outcome which will actually occur. For example, the decision-maker in Worked Example 9.13 should always remember that there is still a 20 per cent chance that the investment will have a negative NPV of –$100,000.

Other methods of assessing risk

There are a number of other methods which are becoming increasingly popular as means of modelling the uncertainty around investment cash flows as the availability of sophisticated computerized spreadsheets and increased processing power has made possible the use of more complex mathematical techniques.

The Monte Carlo simulation method involves the use of a probability distribution and random numbers to estimate net cash-flow figures. If this is repeated many times, a distribution of possible NPVs is derived from which it is possible to ascertain the uncertainty surrounding the project. Similar methods for modelling uncertainty include the use of Markov chain theory and fuzzy set theory. These methods allow unknown cash flows to be represented by a range of inexact (‘fuzzy’) numbers for the purposes of modelling NPV outcomes.

Taking a broader strategic view

So far we have looked at investment appraisal as an isolated financial exercise. The techniques we have examined, although widely used, have been criticized for not taking into account wider strategic considerations. In this last section we will therefore look at some recent developments in investment appraisal which have been aimed at integrating a broader strategic focus into the financial evaluation of individual investment decisions.

Real options

The traditional investment appraisal techniques we have examined in this chapter take a very narrow financial focus. This is exemplified by the concept of relevant cash flows, whereby any cost or revenue deemed not to be relevant to an investment is excluded from the calculation. However, when looking at an investment from a wider strategic perspective, a business may wish to build in flexibility which will give it options in the future. For example, if investing in a new production facility, a company may build a new factory which is twice the size of that needed for current production capacity. It will do this in anticipation of future growth. The problem with applying traditional approaches to investment appraisal in this case is that the extra cost of the large factory in relation to the revenues based upon current capacity may result in a negative NPV.

The concept of real options borrows from financial options, which are options to exchange a financial asset such as a share for cash. A real option is the option to exchange a real asset for some other asset. For example, buying a prime plot of land can give a food retailer a real expansion option to acquire the revenues from a new outlet by paying the cost of building a new store on that land. The further option to sell the land in the future, should the new store prove to be less profitable than anticipated, is a real abandonment option.

Value chain analysis

One way of evaluating a project’s strategic issues as well as its cash flows is to undertake value chain analysis. This involves identifying strategically important value-creating activities. The ‘value chain’ is that set of activities which link from basic raw materials through to the ultimate end product. Focusing on these activities involves finding opportunities to enhance customer value or lower production costs. It has been found in practice that value chain analysis can produce very different investment decisions from those using traditional techniques, as the linkages between different activities within the value chain become an important aspect of the decision process.

Cost-driver analysis

Cost-driver analysis borrows from the concepts of activity-based costing which were examined in Chapter 8. It involves identifying those cost drivers which flow from the organization’s investment decisions. By making these connections more explicit, the organization is able to identify the impact on future cash flows which an investment will make.

Competitive advantage analysis

Competitive advantage analysis involves evaluating whether an investment’s benefits are consistent with the organization’s competitive positioning strategy, such as cost minimization or differentiation. Projects can be ranked according to their ability to contribute towards the organization’s chosen strategy.

Extract 9.4: Cisco – integrating the wider strategic picture

Cisco Systems is a US multinational corporation based in San Jose, California, that designs, manufactures, and sells networking equipment. During the economic boom of the late 1990s and early 2000s, middle managers were given great freedom to acquire business start-ups for the technology and ideas. However, during the economic downturn that followed, Cisco tightened up their investment procedures by creating an investment review board that met monthly to vet potential acquisitions. Managers proposing acquisitions were required not only to demonstrate the potential financial benefits but also to draw up detailed integration plans.

Conclusion

This chapter has examined a multitude of investment appraisal techniques. It has presented those techniques traditionally used for investment appraisal together with some more recent innovations. In particular, we have evaluated each technique, pointing out its strengths and weaknesses. The reader will have noted that all the techniques presented in this chapter have both strengths and drawbacks. It might therefore be concluded that reliance upon one technique alone may lead to sub-optimal decision making or even to failure. On a practical level, therefore, it makes sense for an organization to use a mixture of techniques in order to eliminate or minimize the drawbacks of each individual technique used.

We hope that as a result of studying this chapter the reader will have a better understanding of how different investment appraisal techniques should be applied, will be able to use them more effectively to evaluate investments and will be able to identify and avoid common mistakes in the application of the techniques.

COMPREHENSION QUESTIONS

Why is good investment appraisal important to organizations?
What are the three main factors that should be considered when appraising a potential investment?
What are the main drawbacks of the payback method of investment appraisal?
Explain the concept of the time value of money.
What is the ‘discount rate’ used in NPV calculations and how is it arrived at?
What is an opportunity cost and why should it be included in an investment appraisal calculation?
In what ways can taxation impact upon cash flows from an investment?
Explain two ways in which risk assessment can be incorporated into investment appraisal.

Answers on pages 366–367

Exercises

Answers on pages 368–372

Exercise 9.1: Basic computations

A company is considering investing in a new production facility at a cost of $120 million. The new facility is expected to produce annual cost savings as set out in Table 9.21. The facility is expected to have a useful life of eight years, before becoming obsolete and requiring replacement. The company has a policy of depreciating all assets on a straight-line basis.

Table 9.21

Year	Annual cost savings
1	$30m
2	$35m
3	$40m
4	$45m
5	$30m
6	$26m
7	$15m
8	$15m

Required:

Evaluate the investment using the following techniques:

(a) Payback period – the company considers a capital investment to be acceptable if it pays back within four years. Should the company make the investment?

(b) ARR – what is the accounting rate of return on the average capital employed?

(c) NPV – if the capital investment has a required rate of return of 12 per cent, what is its net present value? Should the company make the investment?

Exercise 9.2: Understanding principles

Freshfare Co is a food retailer with 25 stores in the south of the country in which it operates. The board of directors are currently considering expansion into the north of the country by opening a large new store in a major northern city.

The investment in the new store is estimated to cost $40m. This will be financed mainly through a new bank loan of $35m at a cost of 8 per cent a year. The investment is expected to pay back within three years with an IRR of 22 per cent.

You have been asked to make a presentation on the proposed investment at the next meeting of the board of directors. The directors have raised some queries regarding the calculations in the investment appraisal and would like you to address the following points in your presentation:

A feasibility study for the new store has already been completed at a cost of $28,000. This cost has not been included in the investment appraisal calculations.
The interest payments on the bank loan of $35m will be payable quarterly. These payments have not been included in the investment appraisal calculations.
The chief accountant proposes to charge 5 per cent of central office administration costs to the new store. This charge has not been included in the investment appraisal calculations.
The company has a policy of depreciating all new investments on a straight-line basis over four years. No depreciation charge has been included in the investment appraisal calculations.
When the new store opens, it will be managed by one of the company’s most experienced store managers. This manager earns $40,000 per year and this cost has been included in the investment appraisal calculations. When the manager moves to the new store, her assistant manager will be promoted to take over her current job. The assistant manager currently earns $25,000 per year but will receive a salary increase to $30,000 per year when he is promoted.

Required:

Make notes for your presentation to the board of directors which explain the treatment of each of the five issues above. You should state whether you agree with the accounting treatment in each case. If you disagree with the accounting treatment, you should explain why and propose an alternative.

Exercise 9.3: Financial appraisal within context

ANG Co is a manufacturer of high-performance processor chips for smart phones and other mobile devices. The company, based in Europe, has grown rapidly over the last five years. It has been able to compete with global competitors through developing a highly skilled and loyal workforce.

The company forecasts continued growth in existing markets and intends to break into the new markets of China and South East Asia. With this in mind, the directors have been examining options for opening a new factory within the next 18 months.

The directors have identified three possible new sites for the factory. You have been appointed as a business consultant to help the business choose which site to develop.

The financial information for each factory is set out in Table 9.22.

Table 9.22

	Factory A	Factory B	Factory C
Initial cost	$150m	$150m	$140m
Expected production life	5 years	5 years	4 years

The company accountant has calculated the information shown in Table 9.23.

Table 9.23

	Factory A	Factory B	Factory C
Payback period	3 years	2 years	2 years
Accounting rate of return	29%	29%	32%
Net present value	$25.6m	$39.4m	$28.7m

The NPV is calculated using the company’s standard discount rate of 13 per cent. The following further details are provided:

Factory A: This factory will be opened next to the existing factory. This will provide more jobs for people in the area and possible promotion opportunities for existing employees.

Factory B: Factory B will be located in a new enterprise development zone which is situated approximately 150 kilometres from the existing factory. By opening the factory here, the company can take advantage of some generous tax breaks and other incentives offered by the government. Opening this factory will involve moving some of the existing production into the new factory. This will mean making 20 per cent of the existing workforce redundant. (The cost of redundancies is built into the figures above.)

Factory C: This factory will be opened in China. The company will benefit from cheaper labour costs (this is built into the figures above). The company will also be in a strong geographic position to grow sales in the newly opened market in China and South East Asia.

Required:

Write a report to the directors of ANG Co which evaluates each of the three potential investments using the financial and non-financial information provided above. State what further information the directors might need to consider before making a final decision.

Answers to comprehension questions

Good investment appraisal is important in ensuring that new investments offer acceptable financial returns and that they contribute towards achieving organizational strategic objectives.
The three main factors that should be considered when appraising a potential investment are risk, return and timing.
The main drawbacks of the payback method are that:
– it ignores cash flows outside of the payback period;
– it provides no information about total return;
– it does not differentiate between different timing of cash flows within the payback period.
The time value of money refers to the fact that when payments are made or received has an impact upon their value to the investor.
The discount rate used in NPV calculations is the percentage rate at which the estimated cash flows from the investment are discounted. The discount rate will be arrived at by incorporating the rate of return from the investment required by investors (this must exceed financing costs) adjusted for inflation and the risk of the investment. Investment perceived as being more risky will be evaluated using higher discount rates.
An opportunity cost is the cost of an alternative course of action which must be forgone in order to undertake the investment in question. Opportunity cost is measured in terms of financial contribution. It should always be included in investment appraisal calculations to reflect the fact that when resources are limited there is always a cost of diverting them from elsewhere.
Taxation impacts upon cash flows from an investment in two main ways: taxation paid on earnings from an investment is a cash outflow; and capital allowances on assets purchased for an investment will reduce the amount of taxation paid by the business.
Risk assessment can be incorporated into investment appraisal in a number of ways. These include:
– adjusting the discount rate used in NPV calculations;
– performing sensitivity analysis on investment appraisal calculations;
– undertaking scenario analysis to evaluate a range of different possible outcomes;
– assigning probabilities to different possible outcomes and calculating expected values;
– using mathematical models such as the Monte Carlo simulation method or fuzzy sets.

Answers to exercises

Exercise 9.1: Basic computations

Payback period

The payback period can be seen by calculating the cumulative cash flow from the investment (Table 9.24).

Table 9.24

Year	Cash flow $	Cumulative cash flow $
0	(120)	(120)
1	30	(90)
2	35	(55)
3	40	(15)
4	45	30
5	30	60
6	26	86
7	15	101
8	15	116

The cumulative cash flow shows that the investment pays back within the fourth year. If it is assumed that the cash flow arises evenly throughout the year, the payback period will be:

3 years + (15/45 × 12 months) = 3 years and 4 months

This payback period is within the company’s requirement of four years. The investment should therefore be accepted.

Accounting rate of return

Total cash inflow over the eight years of the project = $236m

Total depreciation = $120m (the investment will be fully written off by the end of year 8)

Therefore average profit = ($236m – $120m)/8 years = $14.5m

As the investment will be fully written off by the end of year 8, average investment = ($120m + $0)/2 = $60m.

Therefore, ARR = $14.5m/$60m = 24.2 per cent

Net present value

Table 9.25

Year	Cash flow $m	Discount factor (12%)	Present value $m
0	(120)	1.000	(120.00)
1	30	0.893	26.79
2	35	0.797	27.90
3	40	0.712	28.48
4	45	0.636	28.62
5	30	0.567	17.01
6	26	0.507	13.18
7	15	0.452	6.78
8	15	0.404	6.06
Net present value			34.82

The NPV is $34.82m. As this is a positive figure, the investment should be accepted.

Exercise 9.2: Understanding principles

Because the feasibility study has already been completed it is a sunk cost. Only future costs which will change as a result of the decision to invest should be included in the investment appraisal calculation. It is therefore correct to exclude this cost from the calculations.

The cost of financing an investment should not be included within the cash-flow forecasts. It is therefore correct to exclude this cost. When using the IRR technique, financing costs are considered by evaluating whether the predicted IRR is sufficient to meet those costs. In this case the predicted IRR is 22 per cent, which is substantially in excess of the 8 per cent cost of the loan. In any case, it is incorrect to evaluate an investment purely against the source of financing. The investment must meet the overall return requirements of the business and not just the cost of the loan to finance the store.

Unless it is expected that central office administration costs will increase as a result of opening a new store, these costs should not be included, as they will be incurred anyway, even if the investment does not go ahead. However, any additional central office costs which are incurred as a result of opening the new store should be included within the investment appraisal calculations.

Although it is important to charge depreciation for financial accounting purposes, this charge is not relevant to the investment appraisal. The two methods used to evaluate the proposed investment are payback period and IRR. Both of these techniques use cash flows and depreciation is an accounting adjustment, not a cash flow.

This is an example of an opportunity cost. It is incorrect to include the salary of $40,000 of the manager in the investment appraisal calculations, because this salary will be paid regardless of whether or not the new store is opened. The only additional cost which the company will incur as a result of opening the new store is the increase in the salary of the assistant manager. The annual cost included in the investment appraisal should therefore be $5,000, the value of the assistant manager’s salary increase.

Exercise 9.3: Financial appraisal within context

Consultant’s report to the directors of ANG Co

Investment appraisal for the opening of a new factory

Terms of reference

I have been asked to advise the board of directors in relation to its decision to open a new factory in order to extend its production facility. This report sets out my evaluation of the options currently being considered by the board.

Introduction

ANG Co has grown rapidly over the last five years. The company is now seeking to extend its production facility through opening a new factory. In particular, the company intends to break into new markets in China and South East Asia. Any new factory must therefore meet the needs of the company in developing this new market.

Three alternatives have been proposed for the siting of the new factory. The first alternative (Factory A) is to site the factory alongside the existing production facility. The second alternative (Factory B) is to move to a new enterprise development zone approximately 150 km from the existing factory. The third alternative (Factory C) is to open a new factory in China.

Financial evaluation

The cost of each of the investments is very similar. Both of the factories in the existing country will cost $150 million. The proposed factory in China is slightly cheaper at $140 million. All production facilities are expected to have similar lives: the two factories in the existing country will have a production life of five years, whereas the factory sited in China would have a production life of four years.

A financial evaluation of the three options has already been conducted. The potential investments have been evaluated using three commonly used and reliable techniques: payback period; accounting rate of return; and net present value. However, the NPV calculations have all been performed using the company’s standard discount rate of 13 per cent. This has therefore not been adjusted to take account of the differing levels of risk involved with each of the three investments. It is therefore important to consider risk and other non-financial factors alongside the financial evaluations which have already been conducted.

Factory A

This option appears the least attractive in terms of the financial evaluations. It has the longest payback period of three years. The ARR is 29 per cent, which matches that of Factory B but is less than the 32 per cent return offered by Factory C. This investment has the lowest NPV of $25.6 million.

However, there are a number of non-financial factors which, when considered, may make this option more attractive. The current success of the business has been built upon a highly skilled and loyal workforce. By building the new factory alongside the existing production facility, the company will be able to take advantage of the skills of the existing workforce. It would also provide an opportunity for promotion and development of existing staff. This is likely to maintain or increase staff morale and enable ANG Co to retain skilled and experienced staff. These factors make Factory A a lower risk option than the other alternatives, and if the discount rate were adjusted to reflect this then the NPV would appear more attractive in comparison with Factory B and Factory C.

Factory B

This is currently the most financially attractive option as it offers the highest NPV of $39.4 million. Although the ARR of 29 per cent is lower than that offered by Factory C at 32 per cent, the NPV is a more reliable measure of the financial viability of the investment.

However, these financial figures should be tempered with consideration of other factors. This option would involve moving a substantial part of production from the existing facility and making 20 per cent of the existing workforce redundant. This is likely to have a significant negative impact on the morale of remaining employees. This may have an impact upon employee motivation and efficiency and may increase staff turnover. The company would also be losing potentially valuable skilled employees. As the new factory would be opened a substantial distance from the existing factory, new employees would have to be recruited. It will be more difficult to supervise and train these new employees alongside existing staff. This will increase the difficulty and timescale of establishing a skilled workforce of the calibre of the existing factory. The company also needs to consider the risks of relying upon tax breaks in a new enterprise development zone. There is a risk that the government may reduce or withdraw these breaks after a short period and this would have a negative impact upon the projected financial figures.

Factory C

This option is financially attractive. It offers the highest ARR, a two-year payback period and a reasonable NPV of $28.7 million. It also requires a slightly lower investment than the other two alternatives, which would save the company $10 million in setup costs. However, the expected production life of this factory is only four years, against a five-year life from the first two options.

The major advantage of this option is that it would put production on the doorstep of the new market which ANG Co is seeking to develop. This may offer several advantages in terms of supply time and reaction to changes in market demands. However, in terms of management control, this option carries the highest risk. The company currently has no experience of operating a production facility in China. The new factory would be at a greater geographic distance from the existing business, which will increase problems of control and communication. The company would also need to recruit a new workforce in an unknown market. This means that the quality and reliability of employees in the new factory will be unknown.

As this option carries the highest risk, the discount rate used in the NPV calculation should have been increased. If the NPV were to be recalculated using a higher discount rate, this option might appear substantially less financially attractive.

Recommendations

Each of the three options offers different strategic advantages to ANG Co. However, they all carry very different risks. Before a final decision is made, it is recommended that the NPV calculations are adjusted to take account of these different risks.