INVESTMENT ANALYSIS

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INVESTMENT ANALYSIS

OR

CAPITAL BUDGETING

What is Capital Budgeting?

THE PROCESS OF PLANNING

EXPENDITURES ON ASSETS WHOSE

RETURN WILL EXTEND BEYOND ONE

YEAR.

INVESTMENT

THE ADDITION OF DURABLE

ASSETS TO A BUSINESS

INVESTMENT

OPPORTUNITIES

MAINTENANCE AND REPLACEMENT

OF DEPRECIABLE CAPITAL ITEMS

ADOPTION OF COST-REDUCING

INVESTMENTS

ADOPTION OF INCOME-INCREASING

INVESTMENTS

A COMBINATION OF THE

PRECEDING

STEPS IN INVESTMENT ANALYSIS:

1.

IDENTIFY POTENTIALLY

PROFITABLE INVESTMENT

ALTERNATIVES

2.

COLLECT RELEVANT DATA ON:

CAPITAL OUTLAYS

COSTS

RETURNS

3.

USE AN APPROPRIATE METHOD

TO ANALYZE THE DATA.

4.

DECIDE WHETHER TO ACCEPT

OR REJECT THE INVESTMENT

OR SELECT THE TOP RANKING

AMONG MUTUALLY EXCLUSIVE

PROJECTS.

CAPITAL BUDGETING

METHODS OF CAPITAL BUDGETING

PAYBACK METHOD

SIMPLE RATE OF RETURN

NET PRESENT VALUE

INTERNAL RATE OF RETURN

PAYBACK METHOD

THE PAYBACK METHOD GIVES THE

NUMBER OF YEARS NECESSARY TO

RECOVER THE INITIAL

INVESTMENT.

DOES NOT ACCOUNT FOR THE

TIMING OF CASH FLOWS.

P = I / E

WHERE:

P = PAYBACK PERIOD IN YEARS

I= INITIAL INVESTMENT OUTLAY

E = ANNUAL NET CASH FLOWS

(CASH RECEIPTS LESS CASH EXPENSES)

SIMPLE RATE OF RETURN

EXPRESSES THE AVERAGE ANNUAL

NET INCOME AS A PERCENTAGE OF

THE AMOUNT INVESTED.

THIS MAY BE IN TERMS OF THE

INITIAL CAPITAL OUTLAY OR THE

AVERAGE AMOUNT INVESTED OVER

THE USEFUL LIFE OF THE

INVESTMENT.

RETURN AS A PERCENT OF

INITIAL CAPITAL OUTLAY

SRR = Y/I

WHERE:

SRR = SIMPLE RATE OF RETURN

Y = AVERAGE ANNUAL NET

INCOME (DEPRECIATION

TAKEN INTO ACCOUNT)

I = INITIAL INVESTMENT

OUTLAY

CALCULATION OF ANNUAL NET

INCOME

Y =(E – D)

WHERE:

Y = AVERAGE ANNUAL NET INCOME

E = TOTAL EXPECTED ANNUAL NET

CASH RECEIPTS

D= TOTAL ANNUAL DEPRECIATION

STRAIGHT LINE DEPRECIATION

D =(INITIAL COST – SALVAGE VALUE) /

DEPRECIABLE LIFE

RETURN AS A PERCENT OF

AVERAGE AMOUNT INVESTED

SRR / = Y/ (I + S)/2

WHERE:

I = INITIAL INVESTMENT

S = SALVAGE VALUE

NET PRESENT VALUE (NPV)

WITH THE NPV, THE CASH FLOWS

OF THE INVESTMENT ARE

DISCOUNTED BY A MINIMUM

ACCEPTABLE COMPOUND ANNUAL

RATE OF RETURN.

THE INVESTMENT IS JUDGED TO

BE ACCEPTABLE IF THE PRESENT

VALUE OF THE NET CASH FLOWS

EXCEEDS THE INITIAL

INVESTMENT OUTLAY.

NPV = - INV + P

1

+ …. + P

N

/(1+i) + P

/(1+i) N + V

N

2

/(1+i) 2

/(1+i) N

WHERE:

INV = INITIAL INVESTMENT

P

N

V

N

= ANNUAL NET CASH FLOWS

ATTRIBUTED TO THE

INVESTMENT

= SALVAGE VALUE OR

TERMINAL INVESTMENT VALUE

N = LENGTH OF PLANNING

HORIZON

I = THE INTEREST RATE OR

REQUIRED RATE-OF-RETURN OR

DISCOUNT RATE

INTERNAL RATE OF RETURN

(IRR)

THE IRR IS THE COMPOUND

INTEREST RATE THAT EQUATES THE

PRESENT VALUE OF THE FUTURE

NET CASH FLOWS WITH THE

INITIAL OUTLAY.

OR IN OTHER WORDS THE

DISCOUNT RATE THAT GIVES A NPV

= ZERO

BOTH THE NPV AND IRR TAKE

INTO ACCOUNT THE TIME VALUE

OF MONEY.

THE PURPOSE OF THESE

INVESTMENT ANALYSIS

TECHNIQUES IS TO EVALUATE

THE ACCEPTABILITY OF

INVESTMENTS RELATIVE TO AN

ACCEPTABLE RATE OF RETURN.

COMPARING NPV AND IRR

AS THE DISCOUNT RATE USED TO

CALCULATE NET PRESENT VALUE IS

INCREASED THE NPV WILL

DECREASE

THE IRR IS THE DISCOUNT RATE

THAT GIVES A NPV OF ZERO

REINVESTMENT

ASSUMPTION

THE IRR METHOD IMPLICITLY ASSUMES

THAT NET CASH INFLOWS FROM AN

INVESTMENT ARE REINVESTED TO EARN

THE SAME RATE AS THE INTERNAL RATE

OF RETURN.

THE NPV METHOD ASSUMES THAT NET

CASH INFLOWS CAN BE REINVESTED AT

THE DISCOUNT RATE USED.

WHICH REINVESTMENT RATE IS

MORE REALISTIC?

THE DISCOUNT RATE USED TO

CALCULATE THE NPV HAS THE

ADVANTAGE OF BEING

CONSISTENTLY APPLIED TO ALL

INVESTMENTS BEING EVALUATED.

CASH FLOWS FOR THREE

INVESTMENTS

1

2

YEAR

0

3

4

5

AVG

INV A INV B INV C

-20,000 - 20,000 - 20,000

2,000

4,000

5,800

5,800

10,000

8,000

6,000

8,000

10,000

6,000

5,800

5,800

5,800

5,800

6,000

3,000

1,000

5,600

A

B

C

PAYBACK PERIOD

20000/6000 = 3.33 YEARS

20000/5800 = 3.45 YEARS

20000/5600 = 3.57 YEARS

SIMPLE RATE OF RETURN

A (30000-20000)/5 = 2000

• 2000/20000 = 0.10 10%

B (29000-20000)/5 = 1800

• 1800/20000 = 0.09 9%

C (28000-20000)/5 = 1600

• 1600/20000 = 0.08 8%

* Assume that the investment is fully depreciated in 5 years

NET PRESENT VALUE

A NPV = -20000 + 2000/(1.08)

+ 4000/(1.08) 2 + 6000/(1.08) 3

+ 8000/(1.08) 4 + 10000/(1.08) 5

+ 0/(1.08) 5

NPV = -20000 + 1852 + 3429

+ 4763 + 5880 + 6806 + 0

NPV = 2730

NET PRESENT VALUE AND

INTERNAL RATE OF RETURN

A NPV = 2730 IRR = 12.01

B NPV = 3158

C NPV = 3766

IRR = 13.82

IRR = 17.57

WHAT GOES INTO THE DISCOUNT

RATE?

THE DISCOUNT RATE SHOULD

REFLECT THE COST OF CAPITAL OR

THE COST OF FUNDS USED TO

FINANCE THE BUSINESS.

AN INVESTMENT IS NOT

ACCEPTABLE UNLESS IT

GENERATES A RETURN SUFFICIENT

TO COVER THE COST OF FUNDS.

THE DISCOUNT RATE CONTAINS

THREE COMPONENTS:

REAL RISK-FREE RATE

RISK PREMIUM

INFLATION EXPECTATIONS

WEIGHTED AVERAGE COST

OF CAPITAL

THERE ARE TWO TYPES OF CAPITAL

INVESTED IN A BUSINESS:

DEBT CAPITAL

EQUITY CAPITAL

COST OF DEBT

COST OF EQUITY

WEIGHTED AVERAGE COST

OF CAPITAL

K c

= w d

Where:

K d

+ w e

K e

K c is the weighted average cost of capital w d is the proportion of assets financed with debt

K d is the cost of debt capital w e is the proportion of assets financed with equity

K e is the cost of equity capital

PROFITABILITY INDEX

USED TO ALLOCATE LIMITED

CAPITAL AMONG SEVERAL

INDEPENDENT PROJECTS

PRESENT VALUE OF THE CASH

INFLOWS DIVIDED BY THE INITIAL

CASH OUTLAY

ANNUITY EQUIVALENT

USED TO COMPARE NPVs WITH UNEQUAL

LIVES.

DETERMINES THE SIZE OF ANNUAL

ANNUITY FOR THE ECONOMIC LIFE OF

THE INVESTMENT THAT COULD BE

PROVIDED BY A SUM EQUAL TO THE

PRESENT VALUE OF ITS PROJECTED

CASH FLOW STREAM, GIVEN THE COST

OF CAPITAL.

ANNUITY EQUIVALENT IS

CALCULATED BY SETTING THE NPV

OF THE INVESTMENT AS THE PV

AND THEN SOLVING FOR THE PMT

USING THE SAME PLANNING

HORIZON AND DISCOUNT RATE TO

DETERMINE NPV.

FINANCIAL FEASIBILITY

ONCE YOU HAVE EVALUATED AN

INVESTMENT, THE FINANCING OF

THE PROJECT SHOULD BE

DETERMINED.

AFTER-TAX CASH FLOWS MAY NOT

BE SUFFICIENT TO MEET DEBT

REPAYMENT REQUIREMENTS.

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