BLC Inc. is a medium-sized manufacturing company based in the UK. The company operates mainly in the London area and is based in Peterborough. At a recent board meeting, the company decided to expand its activities, and to lease additional temporary premises in London in order to cope with additional demand.

Analyse the data related to anticipate cash flows resulting from BLC?s expansion to either of two potential new premises. Your group will collaborate to make a recommendation.

To prepare for this assignment

• Review the financial data below. The company has narrowed the choice to the following two alternatives, with the following cash flow information being available.
• Use the following data in your analysis:

Year	Property 1 $(000s)	Property 2 $(000s)
0	(2,500)	(2,750)
1	1,000	900
2	500	700
3	600	800
4	1,000	600
5	900	600

Note 1: The Company?s current cost of capital is 10%. Note 2: Ignore taxation.

• Explain the tools that you believe would help you to reach a decision.
• If you were a decision-maker in this organisation, which calculations and measures would you want at your disposal before making your choice?
• Are there other, non-financial factors that may play a role in your decision?
• Additionally, include your recommendation to the company which option it should take.
• Support your decision with an interpretation of any calculations you performed, as well as an explanation of any other factors you considered.

Chapter 10 Making capital investment decisions Introduction This chapter is the first of three dealing with the area generally known as financial management. In this chapter we shall look at how businesses can make decisions involving investments in new plant, machinery, buildings and other long-term assets. In making these decisions, businesses should be trying to pursue their key financial objective, which is to enhance the wealth of the owners (shareholders). Investment appraisal is a very important area for businesses; expensive and far-reaching consequences can flow from bad investment decisions. Learning outcomes When you have completed this chapter, you should be able to: explain the nature and importance of investment decision making; identify the four main investment appraisal methods found in practice; use each method to reach a decision on a particular investment opportunity; discuss the attributes of each of the methods. Remember to create your own personalized Study Plan The nature of investment decisions The essential feature of investment decisions is time. Investment involves making an outlay of something of economic value, usually cash, at one point in time, which is expected to yield economic benefits to the investor at some other point in time. Usually, the outlay precedes the benefits. Also, the outlay is typically one large amount and the benefits arrive as a series of smaller amounts over a fairly protracted period. Investment decisions tend to be of profound importance to the business because: Large amounts of resources are often involved. Many investments made by businesses involve laying out a significant proportion of their total resources (see Real World 10.2). If mistakes are made with the decision, the effects on the businesses could be significant, if not catastrophic. It is often difficult and/or expensive to bail out of an investment once it has been undertaken. Investments made by a business are often specific to its needs. For example, a hotel business may invest in a new, custom-designed hotel complex. The specialist nature of this complex will probably lead to its having a rather limited secondhand value to another potential user with different needs. If the business found, after having made the investment, that room occupancy rates were not as buoyant as was planned, the only possible course of action might be to close down and sell the complex. This would probably mean that much less could be recouped from the investment than it had originally cost, particularly if the costs of design are included as part of the cost, as they logically should be. Real World 10.1 gives an illustration of a major investment by a well-known business operating in the UK. Real World 10.1 Brittany Ferries launches an investment Brittany Ferries, the cross-channel ferry operator, recently bought an additional ship, named Cap Finistre. The ship cost the business 181.5 million and has been used on the Portsmouth to Santander route since Spring 2010. Although Brittany Ferries is a substantial business, this level of expenditure was significant. Clearly, the business believed that acquiring the new ship would be profitable for it, but how would it have reached this conclusion? Presumably the anticipated future cash flows from passengers and freight operators will have been major inputs to the decision. Source: www.brittany-ferries.co.uk. The kind of issues raised by Brittany Ferries' investment will be the main subject of this chapter. Real World 10.2 indicates the level of annual net investment for a number of randomly selected, wellknown UK businesses. It can be seen that the scale of investment varies from one business to another. (It also tends to vary from one year to the next for a particular business.) In nearly all of these businesses the scale of investment was significant, despite the fact that many businesses were cutting back on investment during the economic recession. Real World 10.2 The scale of investment by UK businesses Source: Annual reports of the businesses concerned for the financial year ending in 2009. Real World 10.2 is limited to considering the non-current asset investment, but most non-current asset investment also requires a level of current asset investment to support it (additional inventories, for example), meaning that the real scale of investment is even greater, typically considerably so, than indicated above. Activity 10.1 When managers are making decisions involving capital investments, what should the decision seek to achieve? Investment decisions must be consistent with the objectives of the particular business. For a private sector business, maximising the wealth of the owners (shareholders) is usually assumed to be the key financial objective. Investment appraisal methods Given the importance of investment decisions, it is essential that there is proper screening of investment proposals. An important part of this screening process is to ensure that the business uses appropriate methods of evaluation. Research shows that there are basically four methods used in practice by businesses throughout the world to evaluate investment opportunities. They are: accounting rate of return (ARR) payback period (PP) net present value (NPV) internal rate of return (IRR). It is possible to find businesses that use variants of these four methods. It is also possible to find businesses, particularly smaller ones, that do not use any formal appraisal method but rely instead on the 'gut feeling' of their managers. Most businesses, however, seem to use one (or more) of these four methods. We are going to assess the effectiveness of each of these methods and we shall see that only one of them (NPV) is a wholly logical approach. The other three all have flaws. We shall also see how popular these four methods seem to be in practice. To help us to examine each of the methods, it might be useful to consider how each of them would cope with a particular investment opportunity. Let us consider the following example. Example 10.1 Billingsgate Battery Company has carried out some research that shows that the business could provide a standard service that it has recently developed. Provision of the service would require investment in a machine that would cost 100,000, payable immediately. Sales of the service would take place throughout the next five years. At the end of that time, it is estimated that the machine could be sold for 20,000. Inflows and outflows from sales of the service would be expected to be as follows: Note that, broadly speaking, the operating profit before deducting depreciation (that is, before non-cash items) equals the net amount of cash flowing into the business. Broadly, apart from depreciation, all of this business's expenses cause cash to flow out of the business. Sales revenues tend to lead to cash flowing in. Expenses tend to lead to it flowing out. For the time being, we shall assume that inventories, trade receivables and trade payables remain constant. This means that operating profit before depreciation will tend to equal the net cash inflow. To simplify matters, we shall assume that the cash from sales and for the expenses of providing the service are received and paid, respectively, at the end of each year. This is clearly unlikely to be true in real life. Money will have to be paid to employees (for salaries and wages) on a weekly or a monthly basis. Customers will pay within a month or two of buying the service. On the other hand, making the assumption probably does not lead to a serious distortion. It is a simplifying assumption that is often made in real life, and it will make things more straightforward for us now. We should be clear, however, that there is nothing about any of the four methods that demands that this assumption is made. Having set up the example, we shall now go on to consider how each of the appraisal methods works. Accounting rate of return (ARR) The first method that we shall consider is the accounting rate of return (ARR). This method takes the average accounting operating profit that the investment will generate and expresses it as a percentage of the average investment made over the life of the project. Thus: ARR equals Average annual operating profit over Average investment to earn that profit 100 % We can see from the equation that, to calculate the ARR, we need to deduce two pieces of information about the particular project: the annual average operating profit; and the average investment. In our example, the average annual operating profit before depreciation over the five years is 40,000 (that is, 000(20 + 40 + 60 + 60 + 20)/5). Assuming 'straight-line' depreciation (that is, equal annual amounts), the annual depreciation charge will be 16,000 (that is, (100,000 20,000)/5). Thus, the average annual operating profit after depreciation is 24,000 (that is, 40,000 16,000). The average investment over the five years can be calculated as follows: Average investment ; equals ; Cost of machine plus Disposal value over 2 ; equals ; 100,000 plus 20,000 over 2 equals 60,000 ; Thus, the ARR of the investment is ARR equals 24,000 over 60,000 100% equals 40% Users of ARR should apply the following decision rules: For any project to be acceptable it must achieve a target ARR as a minimum. Where there are competing projects that all seem capable of exceeding this minimum rate (that is, where the business must choose between more than one project), the one with the higher (or highest) ARR would normally be selected. To decide whether the 40 per cent return is acceptable, we need to compare this percentage return with the minimum rate required by the business. Activity 10.2 Chaotic Industries is considering an investment in a fleet of ten delivery vans to take its products to customers. The vans will cost 15,000 each to buy, payable immediately. The annual running costs are expected to total 50,000 for each van (including the driver's salary). The vans are expected to operate successfully for six years, at the end of which period they will all have to be sold, with disposal proceeds expected to be about 3,000 a van. At present, the business outsources transport, for all of its deliveries, to a commercial carrier. It is expected that this carrier will charge a total of 530,000 each year for the next six years to undertake the deliveries. What is the ARR of buying the vans? (Note that cost savings are as relevant a benefit from an investment as are net cash inflows.) The vans will save the business 30,000 a year (that is, 530,000 (50,000 10)), before depreciation, in total. Thus, the inflows and outflows will be: The total annual depreciation expense (assuming a straight-line method) will be 20,000 (that is, (150,000 30,000)/6). Thus, the average annual saving, after depreciation, is 10,000 (that is, 30,000 20,000). The average investment will be Average investment equals 150,000 plus 30,000 over 2 equals 90,000 and the ARR of the investment is: ARR equals 10,000 over 90,000 100 % equals 11.1% ARR and ROCE We should note that ARR and the return on capital employed (ROCE) ratio (which we met in Chapter 6) take the same approach to performance measurement. They both relate accounting profit to the cost of the assets invested to generate that profit. ROCE is a popular means of assessing the performance of a business, as a whole, after it has performed. ARR is an approach that assesses the potential performance of a particular investment, taking the same approach as ROCE, but before it has performed. As we have just seen, managers using ARR will require that any investment undertaken should achieve a target ARR as a minimum. Perhaps the minimum target ROCE would be based on the rate that previous investments had actually achieved (as measured by ROCE). Perhaps it would be based on the industryaverage ROCE. Since private sector businesses are normally seeking to increase the wealth of their owners, ARR may seem to be a sound method of appraising investment opportunities. Operating profit can be seen as a net increase in wealth over a period. This implies that relating operating profit to the size of investment made to achieve it seems a logical approach. ARR is said to have a number of advantages as a method of investment appraisal. ROCE seems to be a widely used measure of business performance. Shareholders seem to use this ratio to evaluate management performance. Some businesses even express their financial objective in terms of a target ROCE. It therefore seems sensible to use a method of investment appraisal that is consistent with this overall approach to measuring business performance. It also gives the result expressed as a percentage. It seems that many managers feel comfortable using measures expressed in percentage terms. Problems with ARR Activity 10.3 ARR suffers from a very major defect as a means of assessing investment opportunities. Can you reason out what this is? Consider the three competing projects whose profits are shown below. All three involve investment in a machine that is expected to have no residual value at the end of the five years. Note that all of the projects have the same total operating profits over the five years. (Hint: The defect is not concerned with the ability of the decision maker to forecast future events, though this too can be a problem. Try to remember the essential feature of investment decisions, which we identified at the beginning of this chapter.) The problem with ARR is that it almost completely ignores the time factor. In this example, exactly the same ARR would have been computed for each of the three projects. Since the same total operating profit over the five years (200,000) arises in all three of these projects, and the average investment in each project is 80,000 (that is, 160,000/2), each project will give rise to the same ARR of 50 per cent (that is, 40,000/80,000). Given a financial objective of maximising the wealth of the owners of the business, any rational decision maker faced with a choice between the three projects set out in Activity 10.3 would strongly prefer Project C. This is because most of the benefits from the investment arise within twelve months of investing the 160,000 to establish the project. Project A would rank second and Project B would come a poor third. Any appraisal technique that is not capable of distinguishing between these three situations is seriously flawed. We shall look at why timing is so important later in the chapter. There are further problems associated with the use of ARR. One of these problems concerns the approach taken to derive the average investment in a project. Example 10.2 illustrates the daft result that ARR can produce. Example 10.2 George put forward an investment proposal to his boss. The business uses ARR to assess investment proposals using a minimum 'hurdle' rate of 27 per cent. Details of the proposal were as follows: The boss rejected George's proposal because it failed to achieve an ARR of at least 27 per cent. Although George was disappointed, he realised that there was still hope. In fact, all that the business had to do was to give away the piece of equipment at the end of its useful life rather than to sell it. The residual value of the equipment then became zero and the annual depreciation charge became ([200,000 0]/10) = 20,000 a year. The revised ARR calculation was then as follows: ARR equals 48,000 20,000 over open parenthesis 200,000 plus 0 close parenthesis divided by 2 100% equals 28% ARR is based on the use of accounting profit. When measuring performance over the whole life of a project, however, it is cash flows rather than accounting profits that are important. Cash is the ultimate measure of the economic wealth generated by an investment. This is because it is cash that is used to acquire resources and for distribution to owners. Accounting profit, on the other hand, is more appropriate for reporting achievement on a periodic basis. It is a useful measure of productive effort for a relatively short period, such as a year or half year. It is really a question of 'horses for courses'. Accounting profit is fine for measuring performance over a short period, but cash is the appropriate measure when considering the performance over the life of a project. The ARR method can also create problems when considering competing investments of different size. Activity 10.4 Sinclair Wholesalers plc is currently considering opening a new sales outlet in Coventry. Two possible sites have been identified for the new outlet. Site A has an area of 30,000 sq m. It will require an average investment of 6m and will produce an average operating profit of 600,000 a year. Site B has an area of 20,000 sq m. It will require an average investment of 4m and will produce an average operating profit of 500,000 a year. What is the ARR of each investment opportunity? Which site would you select and why? The ARR of Site A is 600,000/6m = 10 per cent. The ARR of Site B is 500,000/4m = 12.5 per cent. Thus, Site B has the higher ARR. However, in terms of the absolute operating profit generated, Site A is the more attractive. If the ultimate objective is to increase the wealth of the shareholders of Sinclair Wholesalers plc, it might be better to choose Site A even though the percentage return is lower. It is the absolute size of the return rather than the relative (percentage) size that is important. This is a general problem of using comparative measures, such as percentages, when the objective is measured in absolute ones, like an amount of money. If businesses were seeking through their investments to generate a percentage rate of return on investment, ARR would be more helpful. The problem is that most businesses seek to achieve increases in their absolute wealth (measured in pounds, euros, dollars and so on), through their investment decisions. Real World 10.3 illustrates how using percentage measures can lead to confusion. Real World 10.3 Increasing road capacity by sleight of hand During the 1970s, the Mexican government wanted to increase the capacity of a major four-lane road. It came up with the idea of repainting the lane markings so that there were six narrower lanes occupying the same space as four wider ones had previously done. This increased the capacity of the road by 50 per cent (that is, 2/4 100). A tragic outcome of the narrower lanes was an increase in deaths from road accidents. A year later the Mexican government had the six narrower lanes changed back to the original four wider ones. This reduced the capacity of the road by 33 per cent (that is, 2/6 100). The Mexican government reported that, overall, it had increased the capacity of the road by 17 per cent (that is, 50% 33%), despite the fact that its real capacity was identical to that which it had been originally. The confusion arose because each of the two percentages (50 per cent and 33 per cent) is based on different bases (four and six). Source: Gigerenzer, G., Reckoning with Risk, Penguin, 2002. Payback period (PP) The second approach to appraising possible investments is the payback period (PP). This is the length of time it takes for an initial investment to be repaid out of the net cash inflows from a project. Since it takes time into account, the PP method seems to go some way to overcoming the timing problem of ARR - or at first glance it does. Let us consider PP in the context of the Billingsgate Battery example (Example 10.1). We should recall that essentially the project's cash flows are: Note that all of these figures are amounts of cash to be paid or received (we saw earlier that operating profit before depreciation is a rough measure of the cash flows from the project). We can see that if this investment is made, it will be three years before the 100,000 outlay is covered by the inflows. (This is still assuming that the cash flows occur at year ends.) We can demonstrate derivation of the payback period by calculating the cumulative cash flows as follows: We can see that the cumulative cash flows become positive at the end of the third year. Had we assumed that the cash flows arise evenly over the year, the precise payback period would be 2 years + open parenthesis 2 over 3 close parenthesis years = 2 2 over 3 years Where 40 represents the cash flow still required at the beginning of the third year to repay the initial outlay and 60 is the projected cash flow during the third year. The decision rule for using PP is: For a project to be acceptable it would need to have a payback period shorter than a maximum payback period set by the business. If there were two (or more) competing projects whose payback periods were all shorter than the maximum payback period requirement, the project with the shorter (or shortest) payback period should be selected. If, for example, Billingsgate Battery had a maximum acceptable payback period of four years, the project would be undertaken. A project with a longer payback period than four years would not be acceptable. Activity 10.5 What is the payback period of the Chaotic Industries project from Activity 10.2? The inflows and outflows are expected to be: The payback period here is five years; that is, it is not until the end of the fifth year that the vans will pay for themselves out of the savings that they are expected to generate. The PP method has certain advantages. It is quick and easy to calculate. Also, it can be easily understood by managers. The logic of using PP is that projects that can recoup their cost quickly are economically more attractive than those with longer payback periods, that is, it emphasizes liquidity. PP is probably an improvement on ARR in respect of the timing of the cash flows. PP is not, however, the whole answer to the problem. Problems with PP Activity 10.6 In what respect is PP not the whole answer as a means of assessing investment opportunities? Consider the cash flows arising from three competing projects: (Hint: Again, the defect is not concerned with the ability of the manager to forecast future events. This is a problem, but it is a problem whatever approach we take.) The PP for each project is three years and so the PP method would regard the projects as being equally acceptable. It cannot distinguish between those projects that pay back a significant amount early in the three-year payback period and those that do not. In addition, this method ignores cash flows after the payback period. A decision maker concerned with increasing owners' wealth would prefer Project 3 because the cash flows come in earlier. In fact, most of the initial cost of making the investment has been repaid by the end of the second year. Also, the cash flows are greater in total. The cumulative cash flows of each project in Activity 10.6 are set out in Figure 10.1. We can see that the PP method is not concerned with the profitability of projects; it is concerned simply with their payback period. Thus cash flows arising beyond the payback period are ignored. While this neatly avoids the practical problems of forecasting cash flows over a long period, it means that relevant information could be ignored. We may feel that, by favouring projects with a short payback period, the PP method does at least provide a means of dealing with the problems of risk and uncertainty. However, this is a fairly crude approach to the problem. It looks only at the risk that the project will end earlier than expected. However, this is only one of many risk areas. What, for example, about the risk that the demand for the product may be less than expected? There are more systematic approaches to dealing with risk that can be used. PP takes some note of the timing of the costs and benefits from the project. Its key deficiency, however, is that it is not linked to promoting increases in the wealth of the business and its owners. PP will tend to recommend undertaking projects that pay for themselves quickly. Figure 10.1 The cumulative cash flows of each project in Activity 10.6 The payback method of investment appraisal would view Projects 1, 2 and 3 as being equally attractive. In doing so, the method completely ignores the fact that Project 3 provides most of the payback cash earlier in the three-year period and goes on to generate large benefits in later years. The PP method requires the managers of a business to select a maximum acceptable payback period. This maximum period, in practice, will vary from one business to the next. Real World 10.4 looks at a power-saving device used by Tesco, the supermarket chain, and the payback period involved. Real World 10.4 It's payback time at Tesco According to the Confederation of British Industry, 8.5bn a year is wasted on energy just in the UK. That adds up to about 22m tonnes of CO2 - or the equivalent of Scotland's total commercial carbon emissions in a year. There are a number of reasons why so much energy is wasted. But one is a mismatch between the electricity required to run equipment in organisations and the power that is delivered to their premises. That is where voltage power optimisation comes in - a technology that one company, powerPerfector, has a licence to sell in the UK. Angus Robertson, its chief executive, points out that all electrical equipment intended for use on commercial three-phase circuits in Europe is designed to run on 380 volts - the equivalent of 220V in domestic, single-phase circuits. Yet the average voltage supplied in the UK is 419V (242 in single phase), a figure which cannot be changed without a wholesale revamp of the grid, which is out on cost grounds. Mr Robertson explains the problem. 'Take an electric motor. If you put 419V into a motor rated at 380V it doesn't go faster or more efficiently. But it does have to dissipate the extra energy - mostly in the form of heat, which is wasted. If you go into a Tesco with one of our VPO units, the compressors for the refrigerators are not running so hot, so the air conditioning doesn't have to work so hard - so there's a compounding of benefits.' There are further bonuses. 'We expect light bulbs to last twice as long,' says Mr Robertson. 'And when we installed a unit at Buxton Press, the decibel level dropped drastically. The electric motors were less hot, so making less noise. Maintenance intervals increased too.' The maintenance-free unit, which is fitted at the point where a three-phase power supply enters the building, can save up to 20 per cent in energy costs, says powerPerfector, depending on the quality of the supply and the types of electrical equipment in use. Nationwide, the company says, it can provide an average 13 per cent kWh reduction, which, it says, means the approximate payback period for a supermarket is 18 months, an office two years, and a school three years. Tesco is putting in about 500 powerPerfector units this year, at a cost of about 25m, as part of a rolling programme that will see the equipment in most of its 2,300 stores and distribution centres across the UK. 'We expect to save 5 to 8 per cent of each store's total energy usage,' says Bukky Adegbeyeni, head of the environmental team at the store chain. 'We expect our return on investment to be about 20 per cent, so we will achieve payback in five years.' Source: adapted from 'Case study: power efficiency', The Financial Times, 25/11/2009 (Jaggi, R.), copyright The Financial Times Ltd. Net present value (NPV) From what we have seen so far, it seems that to make sensible investment decisions, we need a method of appraisal that both considers all of the costs and benefits of each investment opportunity; and makes a logical allowance for the timing of those costs and benefits. The third of the four methods of investment appraisal, the net present value (NPV) method, provides us with this. Consider the Billingsgate Battery example's cash flows, which we should recall can be summarised as follows: Given that the principal financial objective of the business is to increase owners' wealth, it would be very easy to assess this investment if all of the cash inflows and outflows were to occur now (all at the same time). All that we should need to do would be to add up the cash inflows (total 220,000) and compare them with the cash outflows (100,000). This would lead us to the conclusion that the project should go ahead because the business, and its owners, would be better off by 120,000. Of course, it is not as easy as this because time is involved. The cash outflow (payment) will occur immediately if the project is undertaken. The inflows (receipts) will arise at a range of later times. The time factor is an important issue because people do not normally see 100 paid out now as equivalent in value to 100 receivable in a year's time. If we were to be offered 100 in twelve months' time in exchange for paying out 100 now, we should not be prepared to accept the offer unless we wished to do someone a favour. Activity 10.7 Why would you see 100 to be received in a year's time as not equal in value to 100 to be paid immediately? (There are basically three reasons.) The reasons are: interest lost risk effects of inflation. We shall now take a closer look at these three reasons in turn. Interest lost If we are to be deprived of the opportunity to spend our money for a year, we could equally well be deprived of its use by placing it on deposit in a bank or building society. In this case, at the end of the year we could have our money back and have interest as well. Thus, by investing the funds in some other way, we shall be incurring an opportunity cost. An opportunity cost occurs where one course of action, for example making a business investment, deprives us of the opportunity to derive some benefit from an alternative action, for example putting the money in the bank and earning interest. From this we can see that any investment opportunity must, if it is to make us wealthier, do better than the returns that are available from the next best opportunity. Thus, if Billingsgate Battery Company sees putting the money in the bank on deposit as the alternative to investment in the machine, the return from investing in the machine must be better than that from investing in the bank, if the machine investment is worth making. If the bank offered a better return, the business, and its owners, would become wealthier by putting the money on deposit. Risk All investments expose their investors to risk. For example, buying a machine to manufacture a product, or to provide a service, to be sold in the market, on the strength of various estimates made in advance of buying the machine, exposes the business to risk. Things may not turn out as expected. Activity 10.8 Can you suggest some areas where things could go other than according to plan in the Billingsgate Battery Company example (basically, buying a machine and using it to render a service for five years)? We have come up with the following: The machine might not work as well as expected; it might break down, leading to loss of the business's ability to provide the service. Sales of the service may not be as buoyant as expected. Labour costs may prove to be higher than expected. The sale proceeds of the machine could prove to be less than were estimated. It is important to remember that the decision whether to invest in the machine must be taken before any of these things are known. For example, it is only after the machine has been purchased that we could discover that the level of sales which had been estimated before the event is not going to be achieved. It is not possible to wait until we know for certain whether the market will behave as we expected before we buy the machine. We can study reports and analyses of the market. We can commission sophisticated market surveys and these may give us more confidence in the likely outcome. We can advertise widely and try to promote sales. Ultimately, however, we have to decide whether to jump off into the dark and accept the risk if we want the opportunity to make profitable investments. Real World 10.5 gives some some impression of the extent to which businesses believe that investment outcomes turn out as expected. Real World 10.5 Size matters Senior finance managers of 99 Cambridgeshire manufacturing businesses were asked how their investments were performing compared to expectations at the time of making the investment decision. The results, broken down according to business size, are set out below. It seems that smaller businesses are much more likely to get it wrong than medium-size or larger businesses. This may be because small businesses are often younger and, therefore, less experienced in the techniques of both forecasting and managing investment projects. They are also likely to have less financial expertise. It also seems that small businesses have a distinct bias towards overoptimism and do not take full account of the possibility that things will turn out worse than expected. Source: Baddeley, M., 'Unpacking the black box: an econometric analysis of investment strategies in real world firms', CEPP Working Paper No. 08/05, University of Cambridge, 2006, p. 14. Normally, people expect to receive greater returns where they perceive risk to be a factor. Examples of this in real life are not difficult to find. One such example is that banks tend to charge higher rates of interest to borrowers whom the bank perceives as more risky. Those who can offer good security for a loan and who can point to a regular source of income tend to be charged lower rates of interest. Going back to Billingsgate Battery Company's investment opportunity, it is not enough to say that we should advise making the investment provided that the returns from it are as high as those from investing in a bank deposit. Clearly we should want returns greater than the level of bank deposit interest rates, because the logical equivalent of investing in the machine is not putting the money on deposit but making an alternative investment that is of similar risk. We have just seen that investors tend to expect a higher rate of return from investment projects where the risk is perceived as being higher. How risky a particular project is and, therefore, how large this risk premium should be are, however, matters that are difficult to handle. It is usually necessary to make some judgement on these questions. Inflation If we are to be deprived of 100 for a year, when we come to spend that money it will not buy as much of goods and services as it would have done a year earlier. Generally, we shall not be able to buy as many tins of baked beans or loaves of bread or bus tickets as we could have done a year earlier. This is because of the loss in the purchasing power of money, or inflation, which occurs over time. Clearly, the investor needs compensating for this loss of purchasing power if the investment is to be made. This compensation is on top of a return that takes account of what could have been gained from an alternative investment of similar risk. In practice, interest rates observable in the market tend to take inflation into account. Rates that are offered to potential building society and bank depositors tend to include an allowance for the rate of inflation that is expected in the future. What will logical investors do? As we have seen, logical investors who are seeking to increase their wealth will only be prepared to make investments that will compensate for the loss of interest and purchasing power of the money invested and for the fact that the returns expected may not materialise (risk). This is usually assessed by seeing whether the proposed investment will yield a return that is greater than the basic rate of interest (which would include an allowance for inflation) plus a risk premium. These three factors (interest lost, risk and inflation) are set out in Figure 10.2. Figure 10.2 The factors influencing the returns required by investors from a project There are three factors that influence the required returns to investors (opportunity cost of finance). Naturally, investors need at least the minimum returns before they are prepared to invest. However, it is in terms of the effect on their wealth that they should logically assess an investment project. Usually it is the investment with the highest percentage return that will make the investor most wealthy, but we shall see later in this chapter that this is not always the case. For the time being, therefore, we shall concentrate on wealth. Let us now return to the Billingsgate Battery Company example. We should recall that the cash flows expected from this investment are: We have already seen that it is not sufficient just to compare the basic cash inflows and outflows for the investment. It would be useful if we could express each of these cash flows in similar terms, so that we could make a direct comparison between the sum of the inflows over time and the immediate 100,000 investment. Fortunately, we can do this. Let us assume that, instead of making this investment, the business could make an alternative investment with similar risk and obtain a return of 20 per cent a year. Activity 10.9 We know that Billingsgate Battery Company could alternatively invest its money at a rate of 20 per cent a year. How much do you judge the present (immediate) value of the expected first year receipt of 20,000 to be? In other words, if instead of having to wait a year for the 20,000, and being deprived of the opportunity to invest it at 20 per cent, you could have some money now, what sum to be received now would you regard as exactly equivalent to getting 20,000 but having to wait a year for it? We should obviously be happy to accept a lower amount if we could get it immediately than if we had to wait a year. This is because we could invest it at 20 per cent (in the alternative project). Logically, we should be prepared to accept the amount that, with a year's income, will grow to 20,000. If we call this amount PV (for present value) we can say: If we derive the present value (PV) of each of the cash flows associated with Billingsgate's machine investment, we could easily make the direct comparison between the cost of making the investment (100,000) and the various benefits that will derive from it in years 1 to 5. We can make a more general statement about the PV of a particular cash flow. It is: PV of the cash flow of year n = actual cash flow of year n divided by (1 + r)n Where n is the year of the cash flow (that is, how many years into the future) and r is the opportunity financing cost expressed as a decimal (instead of as a percentage). We have already seen how this works for the 20,000 inflow for year 1 for the Billingsgate project. For year 2 the calculation would be: PV of year 2 cash flow open parenthesis that is comma 40,000 close parenthesis ; equals ; 40,000 divided by open parenthesis 1 plus 0.2 close parenthesis to the 2 power equals 40,000 divided by open parenthesis 1.2 close parenthesis to the 2 power ; equals ; 40,000 divided by 1.44 equals 27,778 ; Thus the present value of the 40,000 to be received in two years' time is 27,778. Activity 10.10 See if you can show that an investor would find 27,778, receivable now, equally acceptable to receiving 40,000 in two years' time, assuming that there is a 20 per cent investment opportunity. The reasoning goes like this: This is to say that since the investor can turn 27,778 into 40,000 in two years, these amounts are equivalent. We can say that 27,778 is the present value of 40,000 receivable after two years given a 20 per cent cost of finance. Now let us calculate the present values of all of the cash flows associated with the Billingsgate machine project and from them the net present value (NPV) of the project as a whole. The relevant cash flows and calculations are as follows: Once again, we must ask how we can decide whether the machine project is acceptable to the business. In fact, the decision rule for NPV is simple: If the NPV is positive the project should be accepted; if it is negative the project should be rejected. If there are two (or more) competing projects that have positive NPVs, the project with the higher (or highest) NPV should be selected. In this case, the NPV is positive, so we should accept the project and buy the machine. The reasoning behind this decision rule is quite straightforward. Investing in the machine will make the business, and its owners, 24,190 better off than they would be by taking up the next best available opportunity. The gross benefits from investing in this machine are worth a total of 124,190 today. Since the business can 'buy' these benefits for just 100,000 today, the investment should be made. If, however, the present value of the gross benefits were below 100,000, it would be less than the cost of 'buying' those benefits and the opportunity should, therefore, be rejected. Activity 10.11 What is the maximum the Billingsgate Battery Company would be prepared to pay for the machine, given the potential benefits of owning it? The business would logically be prepared to pay up to 124,190 since the wealth of the owners of the business would be increased up to this price - although the business would prefer to pay as little as possible. Using discount tables To deduce each PV in the Billingsgate Battery Company project, we took the relevant cash flow and multiplied it by 1/(1 + r)n. There is a slightly different way to do this. Tables exist that show values of this discount factor for a range of values of r and n. Such a table appears at the end of this book, in Appendix E on pages 563-564. Take a look at it. Look at the column for 20 per cent and the row for one year. We find that the factor is 0.833. This means that the PV of a cash flow of 1 receivable in one year is 0.833. So the present value of a cash flow of 20,000 receivable in one year's time is 16,660 (that is, 0.833 20,000), the same result as we found doing it in longhand. Activity 10.12 What is the NPV of the Chaotic Industries project from Activity 10.2, assuming a 15 per cent opportunity cost of finance (discount rate)? Remember that the inflows and outflow are expected to be: Activity 10.13 How would you interpret this result? The present value of a future receipt (or payment) of 1 depends on how far in the future it will occur. Those that will occur in the near future will have a larger present value than those whose occurrence is more distant in time. The present value of a future receipt (or payment) of 1 depends on how far in the future it will occur. Those that will occur in the near future will have a larger present value than those whose occurrence is more distant in time. The fact that the project has a negative NPV means that the present values of the benefits from the investment are worth less than the cost of entering into it. Any cost up to 126,510 (the present value of the benefits) would be worth paying, but not 150,000. The discount table in Appendix E shows how the value of 1 diminishes as its receipt goes further into the future. Assuming an opportunity cost of finance of 20 per cent a year, 1 to be received immediately, obviously, has a present value of 1. However, as the time before it is to be received increases, the present value diminishes significantly, as is shown in Figure 10.3. Figure 10.3 Present value of 1 receivable at various times in the future, assuming an annual cost of capital of 20 per cent The present value of a future receipt (or payment) of 1 depends on how far in the future it will occur. Those that will occur in the near future will have a larger present value than those whose occurrence is more distant in time. The discount rate and the cost of capital We have seen that the appropriate discount rate to use in NPV assessments is the opportunity cost of finance. This is, in effect, the cost to the business of the finance needed to fund the investment. It will normally be the cost of a mixture of funds (shareholders' funds and borrowings) employed by the business and is often referred to as the cost of capital. We shall refer to it as cost of capital from now on. Why NPV is better From what we have seen, NPV seems to be a better method of appraising investment opportunities than either ARR or PP. This is because it fully takes account of each of the following: The timing of the cash flows. By discounting the various cash flows associated with each project according to when each one is expected to arise, NPV takes account of the time value of money. Associated with this is the fact that by discounting, using the opportunity cost of capital (that is, the return that the next best alternative opportunity would generate), the net benefit after financing costs have been met is identified (as the NPV of the project). The whole of the relevant cash flows. NPV includes all of the relevant cash flows irrespective of when they are expected to occur. It treats them differently according to their date of occurrence, but they are all taken into account in the NPV. They all have an influence on the decision. The objectives of the business. NPV is the only method of appraisal in which the output of the analysis has a direct bearing on the wealth of the owners of the business (with a limited company, the shareholders). Positive NPVs enhance wealth; negative ones reduce it. Since we assume that private sector businesses seek to increase owners' wealth, NPV is superior to the other two methods (ARR and PP) that we have already discussed. We saw earlier that a business should take on all projects with positive NPVs, when their cash flows are discounted at the opportunity cost of capital. Where a choice has to be made between projects, the business should normally select the one with the higher or highest NPV. NPV's wider application NPV is considered the most logical approach to making business decisions about investments in productive assets. The same logic makes NPV equally valid as the best approach to take when trying to place a value on any economic asset, that is, an asset that seems capable of yielding financial benefits. This would include a share in a limited company and a loan. In fact, when we talk of economic value, we mean a value that has been derived by adding together the discounted (present) values of all future cash flows from the asset concerned. Real World 10.6 provides an estimate of the NPV expected from one interesting project. Real World 10.6 A real diamond geezer Alan Bond, the disgraced Australian businessman and America's Cup winner, is looking at ways to raise money in London for an African diamond mining project. Lesotho Diamond Corporation (LDC) is a private company in which Mr Bond has a large interest. LDC's main asset is a 93 per cent stake in the Kao diamond project in the southern African kingdom of Lesotho. Mr Bond says, on his personal website, that the Kao project is forecast to yield 5m carats of diamonds over the next 10 years and could become Lesotho's biggest foreign currency earner. SRK Consulting (mining consultant), has estimated the net present value of the project at 129m. It is understood that Mr Bond and his family own about 40 per cent of LDC. Mr Bond has described himself as 'spearheading' the Kao project. Source: adapted from 'Bond seeks funds in London to mine African diamonds', The Financial Times, 22/04/2007 (Bream, R.), copyright The Financial Times Ltd. Internal rate of return (IRR) This is the last of the four major methods of investment appraisal that are found in practice. It is quite closely related to the NPV method in that, like NPV, it also involves discounting future cash flows. The internal rate of return (IRR) of a particular investment is the discount rate that, when applied to its future cash flows, will produce an NPV of precisely zero. In essence, it represents the yield from an investment opportunity. Activity 10.14 We should recall that, when we discounted the cash flows of the Billingsgate Battery Company machine investment opportunity at 20 per cent, we found that the NPV was a positive figure of 24,190 (see page 374). What does the NPV of the machine project tell us about the rate of return that the investment will yield for the business (that is, the project's IRR)? The fact that the NPV is positive when discounting at 20 per cent implies that the rate of return that the project generates is more than 20 per cent. The fact that the NPV is a pretty large figure implies that the actual rate of return is quite a lot above 20 per cent. We should expect increasing the size of the discount rate to reduce NPV, because a higher discount rate gives a lower discounted figure. It is somewhat laborious to deduce the IRR by hand, since it cannot usually be calculated directly. Iteration (trial and error) is the approach that must usually be adopted. Fortunately, computer spreadsheet packages can deduce the IRR with ease. The package will also use a trial and error approach, but at high speed. Despite it being laborious, we shall now go on and derive the IRR for the Billingsgate project by hand. Let us try a higher rate, say 30 per cent, and see what happens. In increasing the discount rate from 20 per cent to 30 per cent, we have reduced the NPV from 24,190 (positive) to 1,880 (negative). Since the IRR is the discount rate that will give us an NPV of exactly zero, we can conclude that the IRR of Billingsgate Battery Company's machine project is very slightly below 30 per cent. Further trials could lead us to the exact rate, but there is probably not much point, given the likely inaccuracy of the cash flow estimates. It is probably good enough, for practical purposes, to say that the IRR is about 30 per cent. The relationship between the NPV method discussed earlier and the IRR is shown graphically in Figure 10.4 using the information relating to the Billingsgate Battery Company. Figure 10.4 The relationship between the NPV and IRR methods If the cost of capital were zero, the NPV would be the sum of the net cash flows. In other words, no account would be taken of the time value of money. However, if we assume increasing costs of capital, there is a corresponding decrease in the NPV of the project. When the NPV line crosses the horizontal axis there will be a zero NPV. The point where it crosses is the IRR. In Figure 10.4, where the cost of capital is equal to zero, the NPV will be the sum of the net cash flows. In other words, no account is taken of the time value of money. However, as the cost of capital increases there is a corresponding decrease in the NPV of the project. When the NPV line crosses the horizontal axis there will be a zero NPV. That point represents the IRR. Activity 10.15 What is the internal rate of return of the Chaotic Industries project from Activity 10.2? (Hint: Remember that you already know the NPV of this project at 15 per cent (from Activity 10.12).) Since we know that, at a 15 per cent discount rate, the NPV is a relatively large negative figure, our next trial is using a lower discount rate, say 10 per cent: This figure is close to zero NPV. However, the NPV is still negative and so the precise IRR will be a little below 10 per cent. We could undertake further trials in order to derive the precise IRR. If, however, we have to derive the IRR manually, further trials can be time-consuming. We can get an acceptable approximation to the answer fairly quickly by first calculating the change in NPV arising from a 1 per cent change in the discount rate. This can be done by taking the difference between the two trials (that is, 15 per cent and 10 per cent) that we have already carried out (in Activities 10.12 and 10.15): The change in NPV for every 1 per cent change in the discount rate will be (21.03/5) = 4.21 The reduction in the 10% discount rate required to achieve a zero NPV would therefore be: [(2.46)/4.21] 1% = 0.58% The IRR is therefore (10.00 0.58)% = 9.42% However, to say that the IRR is about 9 or 10 per cent is near enough for most purposes. Note that this approach assumes a straight-line relationship between the discount rate and NPV. We can see from Figure 10.4 that this assumption is not strictly correct. Over a relatively short range, however, this simplifying assumption is not usually a problem and so we can still arrive at a reasonable approximation using the approach that we took in deriving the 9.42 per cent IRR. In practice, most businesses have computer software packages that will derive a project's IRR very quickly. Thus, it is not usually necessary either to make a series of trial discount rates or to make the approximation that we have just considered. Users of the IRR method should apply the following decision rules: For any project to be acceptable, it must meet a minimum IRR requirement. This is often referred to as the hurdle rate and, logically, this should be the opportunity cost of capital. Where there are competing projects (that is, the business can choose only one of two or more viable projects), the one with the higher (or highest) IRR should be selected. IRR has certain attributes in common with NPV. All cash flows are taken into account and their timing is logically handled. Real World 10.7 provides some idea of the IRR for one form of renewable energy. Real World 10.7 The answer is blowin' in the wind 'Wind farms are practically guaranteed to make returns once you have a licence to operate,' says Bernard Lambilliotte, chief investment officer at Ecofin, a financial group that runs Ecofin Water and Power Opportunities, an investment trust. 'The risk is when you have bought the land and are seeking a licence,' says Lambilliotte. 'But once it is built and you are plugged into the grid it is risk-free. It will give an internal rate of return in the low to mid teens.' Ecofin's largest investment is in Sechilienne, a French company that operates wind farms in northern France and generates capacity in the French overseas territories powered by sugar cane waste. Source: Batchelor, C., 'A hot topic, but poor returns', FT.com, 27 August 2005. Real World 10.8 gives some examples of IRRs sought in practice. Real World 10.8 Rates of return IRRs for investment projects can vary considerably. Here are a few examples of the expected or target returns from investment projects of large businesses. GlaxoSmithKline plc, the leading pharmaceuticals business, is aiming to increase its IRR from investments in new products from 11 per cent to 14 per cent. Signet Group plc, the jewellery retailer, requires an IRR of 20 per cent over five years when appraising new stores. Apache Capital Partners, a property investment fund, has a target annual IRR of more than 20 per cent. Forth Ports plc, a port operator, concentrates on projects that generate an IRR of at least 15 per cent. Sources: Doherty, J., 'GSK sales jump in emerging markets', FT.com, 4 February 2010; Signet Group plc Annual Report 2009, p. 56; Thomas, D., 'Vultures need to pick time to swoop', FT.com, 12 June 2009; FAQs, Forth Ports plc, www.forthports.co.uk, accessed 9 February 2010. Problems with IRR The main disadvantage of IRR, relative to NPV, is the fact that it does not directly address the question of wealth generation. It could therefore lead to the wrong decision being made. This is because the IRR approach will always rank a project with, for example, an IRR of 25 per cent above a project with an IRR of 20 per cent. Although accepting the project with the higher percentage return will often generate more wealth, this may not always be the case. This is because IRR completely ignores the scale of investment. With a 15 per cent cost of capital, 15 million invested at 20 per cent for one year will make us wealthier by 0.75 million (15 (20 15)% = 0.75). With the same cost of capital, 5 million invested at 25 per cent for one year will make us only 0.5 million (5 (25 15)% = 0.50). IRR does not recognise this. It should be acknowledged that it is not usual for projects to be competing where there is such a large difference in scale. Even if the problem is rare and so, typically, IRR will give the same signal as NPV, a method that is always reliable (NPV) must be better to use than IRR. This problem with percentages is another example of the one illustrated in Real World 10.3. A further problem with the IRR method is that it has difficulty handling projects with unconventional cash flows. In the examples studied so far, each project has a negative cash flow arising at the start of its life and then positive cash flows thereafter. However, in some cases, a project may have both positive and negative cash flows at future points in its life. Such a pattern of cash flows can result in there being more than one IRR, or even no IRR at all. This would make the IRR method difficult to use, although it should be said that this problem is also quite rare in practice. This is never a problem for NPV, however. Some practical points When undertaking an investment appraisal, there are several practical points that we should bear in mind: Past costs. As with all decisions, we should take account only of relevant cost in our analysis. This means that only costs that vary with the decision should be considered. Thus, all past costs should be ignored as they cannot vary with the decision. A business may incur costs (such as development costs and market research costs) before the evaluation of an opportunity to launch a new product. As those costs have already been incurred, they should be disregarded, even though the amounts may be substantial. Costs that have already been committed but not yet paid should also be disregarded. Where a business has entered into a binding contract to incur a particular cost, it becomes in effect a past cost even though payment may not be due until some point in the future. Common future costs. It is not only past costs that do not vary with the decision; some future costs may also be the same. For example, the cost of raw materials may not vary with the decision whether to invest in a new piece of manufacturing plant or to continue to use existing plant. Opportunity costs. Opportunity costs arising from benefits forgone must be taken into account. Thus, for example, when considering a decision concerning whether or not to continue to use a machine already owned by the business, the realisable value of the machine might be an important opportunity cost. These points concerning costs are brought together in Activity 10.16. Activity 10.16 A garage has an old car that it bought several months ago for 3,000. The car needs a replacement engine before it can be sold. It is possible to buy a reconditioned engine for 300. This would take seven hours to fit by a mechanic who is paid 12 an hour. At present, the garage is short of work, but the owners are reluctant to lay off any mechanics or even cut down their basic working week because skilled labour is difficult to find and an upturn in repair work is expected soon. Without the engine, the car could be sold for an estimated 3,500. What is the minimum price at which the garage should sell the car, with a reconditioned engine fitted, to avoid making a loss? (Ignore any timing differences in receipts and payments.) The minimum price is the amount required to cover the relevant costs of the job. At this price, the business will make neither a profit nor a loss. Any price below this amount will result in a reduction in the wealth of the business. Thus, the minimum price is: The original cost of the car is a past cost and is, therefore, irrelevant. However, we are told that, without the engine, the car could be sold for 3,500. This is the opportunity cost of the car, which represents the real benefits forgone, and should be taken into account. The cost of the new engine is relevant because, if the work is done, the garage will have to pay 300 for the engine; it will pay nothing if the job is not done. The 300 is a future cost that varies with the decision and should be taken into account. The labour cost is irrelevant because the same cost will be incurred whether the mechanic undertakes the work or not. This is because the mechanic is being paid to do nothing if this job is not undertaken; thus the additional labour cost arising from this job is zero. Taxation. Owners will be interested in the after-tax returns generated from the business. Thus taxation will usually be an important consideration when making an investment decision. The profits from the project will be taxed, the capital investment may attract tax relief and so on. Tax is levied on these at significant rates. This means that, in real life, unless tax is formally taken into account, the wrong decision could easily be made. The timing of the tax outflow should also be taken into account when preparing the cash flows for the project. Cash flows not profit flows. We have seen that for the NPV, IRR and PP methods, it is cash flows rather than profit flows that are relevant to the assessment of investment projects. In an investment appraisal requiring the application of any of these methods we may be given details of the profits for the investment period. These need to be adjusted in order to derive the cash flows. We should remember that the operating profit before non-cash items (such as depreciation) is an approximation to the cash flows for the period. We should, therefore, work back to this figure. When the data are expressed in profit rather than cash flow terms, an adjustment in respect of working capital may also be necessary. Some adjustment should be made to take account of changes in working capital. For example, launching a new product may give rise to an increase in the net investment made in trade receivables and inventories less trade payables. This working capital investment would normally require an immediate outlay of cash. This outlay for additional working capital should be shown in the NPV calculations as an initial cash outflow. However, at the end of the life of the project, the additional working capital will be released. This divestment results in an effective inflow of cash at the end of the project. It should also be taken into account at the point at which it is received. Year-end assumption. In the examples and activities that we have considered so far in this chapter, we have assumed that cash flows arise at the end of the relevant year. This is a simplifying assumption that is used to make the calculations easier. (However, it is perfectly possible to deal more precisely with the timing of the cash flows.) As we saw earlier, this assumption is clearly unrealistic, as money will have to be paid to employees on a weekly or monthly basis, credit customers will pay within a month or two of buying the product or service and so on. Nevertheless, it is probably not a serious distortion. We should be clear, however, that there is nothing about any of the four appraisal methods that demands that this assumption be made. Interest payments. When using discounted cash flow techniques (NPV and IRR), interest payments should not