Investment project evaluation is an important matter for companies. There are often a variety of different investment opportunities amongst which a company can choose or there is the problem of capital rationing in which limited capital is available for investment. Whatever the particular problem, companies need tools to aid them in selecting the correct opportunity, so that the maximum possible value will be added and they need to be able to do so without referring back to the shareholders and to ask them for their particular preferences.
There are various methods of investment appraisal, of which three will be discussed and implemented here in order to supply the company directors with the best possible advice. The first being the Net Present Value (NPV) calculation that considers relevant future cash flows and subsequently discounts them at the opportunity cost of capital (the Internal Rate of Return (IRR) is similar and will be discussed in more detail later) and the other being the Accounting Rate of Return (ARR) that bases its analysis upon pure, non-discounted, accounting data.
Relevant Cash Flows
Two major methods of project appraisal - NPV and Internal rate of Return (IRR) - are based upon the future relevant cash flows of the project. To use these methods correctly the relevant cash flows have firstly to be defined.
On the next page you can see, in Table 1, a column entitled “Total”. This lists all the various types of income / expense / cash flow that were presented by the directors. From these, the cash flows have to be selected that amongst other things:
- Are future cash flows and not past
- Have an additional / incremental direct impact on the project
- Have a cash impact e.g. are not just simply accounting measures
These will then be the relevant cash flows that can be further used in the project appraisal process. These can be seen in the Table1 column entitled “relevant cash flows” .
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(Please note that the full distribution of the cash flows over the projects’ life can be seen in Appendix I)
The first two items in the above table (ref (a)), are not relevant cash flows because they have either already occurred or have been irreversibly committed to. These are “sunk costs” from the past and will not be effected by the decision to accept or reject the project.
Ref (b) refers to the required purchase price of machinery and should be included as a relevant cash flow. The difference to the above purchased machinery under ref (a) is that in this case the cash flow lies in the future and not in the past. Therefore the outcome of the project evaluation will have an influence.
Both items under ref (c) refer to the depreciation arising from the machinery pur- chased. In both cases the depreciation should not included as a relevant cash flow. This is primarily for two reasons. The first is that depreciation is an accounting measure and not a flow of funds. Depreciation attempts to match the cost of the asset with the stream of revenues produced by it, but has nothing to do with the timing of an actual flow of funds. The second is that if we were to include at least the depre- ciation on the additional equipment, we would be double accounting the negative cash flow, as we have already included the acquisition cost of the additional equip- ment as a cash flow.
The interest expense incurred due to taking up extra debt to finance the purchase of the additional machine (ref d) is a cash flow, but not a relevant one. This is because the companies’ required rate of return of 12% already includes the cost of borrowing the money. To include these cash flows would be to double count them.
The annual sales cash flows (ref (e)) must be included as a positive cash flow. However, it must be noted that it is not the full amount of cash flow from sales activities that is considered, but only the incremental sales that arise directly from taking on the project. Therefore, the cash flow of 95.000 from existing products must be deducted from the total of 470.000 to arrive at the “incremental” cash flow caused by the proposed project of 375.000.
The direct costs of production (ref (f)) will be calculated based upon the incremental project sales and not the total sales.
Warehouse and factory space (ref (g)) should not be included in the relevant cash flows. The costs being charged here are company internal costs. There is no indica- tion that the company intends to rent or sell this property to a third party and conse- quently there is no opportunity cost to the company of not renting to the project in the form of income forgone. It would therefore be incorrect to charge the project with this amount.
The allocated overheads shown in ref (h) should also not be counted as relevant cash flows. This is because in the appraisal of this investment opportunity we should only take “incremental” costs and costs that are “directly attributable” to the project into account. An overhead cost allocation is an accounting issue that also includes costs that have no relation to the project in question. To include these costs in the cash flow would effectively burden the project with costs that have no causal relationship to it. This would lead to an in-accurate appraisal of the proposed project.
NPV and IRR Calculations
Appendix I shows a full cash flow analysis including the calculation of the projects’ Net Present Value (NPV) and Internal Rate of Return (IRR). The analysis runs over a period of 10 years, as this is the estimated life of the product. Furthermore it inte- grates the relevant cash flows as defined in Table 1 into an analysis of their present values over the full project life.
It should be noted that the working capital increase indicated by the directors, will only effect the first period of the project, as the assumption has been made that it will remain relatively constant thereafter.
A further important point with regard to the NPV and IRR calculations is that the
effect of taxes has been completely omitted, as insufficient information was supplied by the directors with regards to the tax situation of the company e.g. whether accu- mulated tax loss carry-forwards exist or the height of the depreciation rate for tax purposes. Tax should normally be considered as a cash outflow in the calculation and the “tax shield” effect of the tax depreciation would be set off against this outflow - in fact this is the only manner in which depreciation factors into such an analysis.
The NPV has been calculated using the below formula amounts to 917.118 for the complete project.
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This calculation discounts the selected relevant cash flows, at the companies required rate of return of 12 % - or in other words at the companies’ opportunity cost of capi- tal. The result is the value of the future cash flows today or the Present Value. This is then set off against the initial investment to arrive at the Net Present Value.
Row 8 in Appendix I shows the Present Value (PV) for each individual period of the project and row 9 shows how these PV’s cumulate to arrive at the final NPV.
The IRR is the rate of return ( 12 % in the above formula) required to produce a NPV of zero. In the case of the proposed project the IRR equals 87.05%.