Investment appraisal methods and value creation in corporate finance

Corporate Finance

Investment Assessment Questions

A business will have a number of choices to make regarding investments. In any commercial environment, even the richest of firms will not have unlimited capital for investment; each investment undertaken is likely to be at the cost of any potential alternate investment. This means a firm has to make decisions to assess which investments are likely to offer the greatest return for the firm. The way the firm appraises the investments and chooses which to pursue and which to reject will have a direct impact on their financial performance. Therefore, it is important that the processes used to assess the potential investments are able to add value to the firm.

Different firms may use different assessment techniques; these may include general assessment and the use of gut feelings, assessment processes may also include other approaches such as pay back period and discounted cash flow models including net present value (NPV) and internal rate of return (IRR) (Cooper at al, 2011, p20; Bennouna et al., 2010, p225). While there may be a discussion regarding which method is superior, different firms may value differing models based on their own situation. The key in understanding how an assessment can add value to a firm is to look at the way assessment may lead to a better decision making process which helps to optimize either the desired returns, or further the organizational goals.

For every investment chosen there is likely to be an associated opportunity cost (Heymann and Bloom, 1990, p7). An opportunity cost is the loss of return from an investment which cannot be made when the capital is used elsewhere. An investment in one project may use the capital which would otherwise be invested in an alternate project. By assessing the potential direct and/or indirect returns a company may choose the option which gives them the best return. This means that the rejected project has a lower return, the company has minimized the opportunity cost as the opportunity cost is the return which will not be realized following the investment choice (Heymann and Bloom, 1990, p7). By assessing the different choices value may be created by minimizing this opportunity cost. Theoretically, if no assessment were taking place, it would be possible that the firm would not choose the optimal investment, demonstrating the way in which value is added.

It may also be argued that further value may be created by taking into account the specific situation of a company, and balancing the different requirements to meet organizational strategies. If an organization needs rapid cash flow, short-term investments with a fast payback period may be more beneficial than more valuable projects which will require a higher level of investment and take longer to provide the needed cash flow. Decisions may also influenced by the amount of capital which is available, or terms and conditions associated with different sources of capital that may be used for various projects. Therefore, an assessment will not only consider which investments may be the most valuable, there will also provide a framework by which the investments which are most suited to the specific company needs may be identified. The processes may sometimes be flawed, but without an assessment process there is a greater potential that non-optimal strategies will be pursued, therefore, by implementing processes which reflect the firms needs, strategies and goals value is created with the ability of the firm to choose optimal, or at least better investment choices compared to a position where no assessment takes place.

Part B

The way assessment take place may vary, three which are often seen are the playback period, NPV and the IRR. Looking at two potential investments, the way these are used may be demonstrated. Each project will be examined using the three methods in order to determine which may be the best for the firm.

Payback period

The payback period assessment is one of the most simple. This method simply takes the net revenues of the project, looking at the accumulated total to determine at which point the initial investment is recouped (Weetman, 2010, p263). This is initially assessed on an annual basis, where the repayment of the initial investment takes place during the year, the revenue for the year is usually assumed to be earned evenly over the year, allowing the assessment to determine the point in the year the payback is achieved (Weetman, 2010, p263).

Project a

Table 1 Payback period for project a

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue

-18,000

4,500

4,500

4,500

4,500

4,500

Accumulative total

-18,000

-13,500

-9,000

-4,500

0

4,500

This shows that the payback is achieved at the end of the forth year for project a

Project B

Table 2 Payback period for project B

Year 0

Year 1

Year 2

Year 3

Year 4

Year 5

Revenue

-27,000

6,500

7,000

8,500

7,500

6,000

Accumulative revenue

-27,000

-20,500

-13,500

-5,000

2,500

8,500

This shows that the break even point is at some point in year 4. To assess this in detail the surplus over the initial investment is divided by the amount earned that year giving 2,000/7,500 = 0.3333. This is the proportion of the year which the firm was earning over the initial investment, converting this into months it is 0.285714 x 12 = 4. Deducting this from 12 months gives 8 months, so the payback period is 3 years 8 months.

Internal Rate of Return

The internal rate of return is based in the use of discounted cash flows with the aim of assess the actual rate of return created by the investment. A key assumption is that money will be reinvested at the same rate. To calculate this, the use of an NPV calculation and then a negative calculation assuming the first was positive, or positive where there was a negative, is used with the following equation

Lower rate of interest or discount rate + (positive value / difference between positive value and negative value x lower discount or interest rate) = IRR

In both cases the rate of 2% is used to create a positive value using the same process above, this gives project a a positive value of 3,211 and for project B. A positive value of 6,471. These are used in the calculation shown below. As the calculations are reversed the IRR will be negative.

Table 5 IRR for Project a

Lowest interest rate

Positive value

Difference between positive and negative

IRR

2

3,211

-4,786

-0.66%

This gives an IRR for project a of -0.66%

Table 6 IRR for Project B

Lowest interest rate

Positive value

Difference between positive and negative

IRR

2

6,474

-7,548

-0.28%

This gives project B. An IRR of -0.028%

Part C

Using the above assessments each may indicate which investment may be preferred. Using the payback period project a has a payback period of 4 years, whereas project B. has a payback period of 3 years 8 months. If the fastest payback period is preferred than project B. will be chosen.

The NPV which discounts the net revenues into a net present value shows that Project a has a loss of 1,576 and the loss for Project B. is 1,074. If assessed only on this basis, project a makes the greatest loss. However, the basic rule of NPV is that investments should only be made in projects where there is a new positive value, otherwise the firm is not earning the amount it is costing them in payments to support the capital used to fund the project (Weetman, 2010, p269).

The IRR calculation also shows a loss for each project, with Project B. making the least loss, indicating that if one of these was to go ahead this would be the least damaging. However, we may argue the firm may be better taking either and not paying for the capital to support the projects.

Part D

It is essential that the assessment make use of a discounted cash flow in order to account for the erosion of the value of money over time. The concept is simple, 100 in cash today will not be worth the same amount buying the same goods in 5 years time. In terms of the firm there is the potential impact of inflation. However, it is usually the WACC which is used as the discount rate. This can be conceived by looking at 100 in capital, if this takes 11.5% to maintain, the value will fall by that amount after one year, and each subsequent year the value will decrease. Therefore, the discounting will mean that the projected revenues can be assessed in terms of their real value rather than numerical value.

Part E

The calculations would change if the cost of capital changed, if it increased the discount rate would increase. If the discount rate was to increase, this would mean the value for money would erode faster, so the NPV would show a greater loss. .

If the cost of capital dropped the discount rate would reduce, for example to 4% this would decrease the rate at which the value of the money erodes, and increase the value of the investment, this would result in the following calculations.

Table 7 NPV for project a at 4% discount rate

Year

Profit

discount rate discounted cash flow

Accumulative total

Year 1

4,500

0.96153846

4,327

4,327

Year 2

4,500

0.92455621

4,161

8,487

Year 3

4,500

0.88899636

4,000

12,488

Year 4

4,500

0.85480419

3,847

16,335

Year 5

4,500

0.82192711

3,699

20,033

Less initial investment

18,000

NPV

2,033

Table 8 NPV for project B. At 4% discount rate

Year

Profit

discount rate discounted cash flow

Accumulative total

Year 1

6,500

0.961538

6,250

6,250

Year 2

7,000

0.924556

6,472

12,722

Year 3

8,500

0.888996

7,556

20,278

Year 4

7,500

0.854804

6,411

26,689

Year 5

6,000

0.821927

4,932

31,621

Less initial investment

27,000

NPV

4,621

In both cases this increases the NPV turning a negative to a positive; this also impacts on the IRR as they become positive, 6.73% for project a and 7.94% for project B. This should be referred to in part g.

Part F

The NPV is a measure that is sensitive to changes. However, it may be argued that long-term projects are more sensitive than short-term projects due to the way in which discounting takes place. The discounting is undertaken on a compound basis, so as time goes by any errors that are present may compound and increase their impact on the result. In a short-term project there is less time for the error to increase as a result of compounding as the result from one year passes to the next. The NPV model is also one that favors higher early return due to the discounting, which also reduces the sensitivity of the model to errors in the earlier years.

Part G

Changes in the cost of capital will impact on the IRR. The cost of capital is used to reduce the net revenue created, so may be seen as a cost being applied. When this cost decreases more revenue is left, so the return increases, when the cost increases, there is less revenue left in the present value, reducing the IRR. The way this may impact on both the projects assessed if the cost of capital reduces to 4% has been assessed in part E. Looking at this another way, if the NPV moves from being negative to positive, the return must also change from being negative to positive.

Part I

NPV and IRR may be compared. There are some clear similarities between both methods, as both have the discounting of cash flows as their basis, which means both processes are likely to favor projects where there are higher shorter term returns (Favaro, 1996, p4). Both are also likely to show increased sensitivity on long-term projects, due to the compound impact discussed in part F.

However, there are some differences. In maybe argued that NPV provides some more useful information, as it presents an actual level of return, reflecting the shareholder wealth which may be created for a particular project at a set discount rate. As the process facilitates the comparison of different projects, with the potential to adjust the discount rate in up to allow for disparate levels of risk, NPV may also be seen as facilitating a greater level of realism. Within this model it should be noted that this calculation makes the assumption that cash flows generated by the project will continue to generate the discount rate or the cost of capital.

The underlying assumption of IRR is different; instead of assuming that the reinvested capital will continue to earn the discount rate, in this model it is assumed that the reinvested cash will continue to earn the same rate as the project it came from, which is inherently at a higher rate. Therefore, IRR may be seen as a more optimistic, which may lead to a greater level of diversions with actual results. Conversely, NPV may be seen as more pessimistic, as it is likely that companies will reinvest cash in other projects that achieve returns above the cost of capital.

While the net present value gives the numerical value, the internal rate of return gives a percentage value. It has been argued that by giving a single percentage measure there is a simpler concept for comparison, especially by individuals who are not fully aware of the way in which calculations take place and the meaning of a net present value (Evans and Forbes, 1993, p89). Therefore, IRR may be seen as conceptually more simple for use in presentations.

Overall, both have advantages and disadvantages, however, NPV has a greater potential for realism, and may also be seen as slightly more conservative, so this writer argues that NPV is superior.