Capital Expenditure Appraisal A Ward 2002 Cash Flow

Capital Expenditure Appraisal ©A. Ward 2002 • Cash Flow - revisited • Accounting Rate of Return • Payback Period • DCF Techniques • Net Present Value • Sensitivity Analysis

Cash Flow Profile Major long-term capital investment project. Net Cash Flow Time ©A. Ward 2002

Cash Flow Profile Periodic replacement with increasing prices. Net Cash Flow Time ©A. Ward 2002

Cash Flow Profile Investment with cyclical cash flows Net Cash Flow Time ©A. Ward 2002

Capital Expenditure - Definition “Funds spent in the expectation of securing a stream of benefits, which may take some time to start flowing and which may last for some years. ” The amount spent is very often substantial. ©A. Ward 2002

Capital Expenditure - Examples ©A. Ward 2002 • Purchase of Plant or Machinery • Purchase of Land • Development of a New Product • Installation of a New Computer System • etc.

Capital Expenditure Appraisal Objectives ©A. Ward 2002 • whether a particular capital expenditure proposal is justified in terms of the expected benefits • if there alternative proposals which should be undertaken

Analysis of Options - Example ©A. Ward 2002

Accounting Rate of Return • Surplus = Cash Inflow - (Initial Investment - Residual Value) • Average Investment = (Initial Investment - Residual Value)/2 ©A. Ward 2002

Cash Inflow Stream ©A. Ward 2002 • Total net cash flow is identical • Pattern of cash inflow is different • There is less risk associated with cash received early, compared to that received later • The earlier that cash is received the quicker it can be recycled into new cash generating ventures (or used to pay-off debts) • Accounting Rate of Return ignores the time value of money.

Payback Period (Breakeven) Recognises the time value of money ©A. Ward 2002

Limitations • Accounting Rate of Return - Ignores the time value of money • Payback Period - Ignores cash after Breakeven • ©A. Ward 2002 There has to be a better way! There is!

Discounted Cash Flow (DCF) • Basic Principle is that the value of money changes with time. Example : £ 100 invested at 10% interest rate is worth £ 110 in 1 year, £ 121 Thus £ 100 now is worth just the same as £ 121 next year • ©A. Ward 2002 Based on Investment Criteria - ignore risk & inflation

Discounted Cash Flow (DCF) ©A. Ward 2002 • Decision : • Is it worth making a £ 100 “investment” now to generate a £ 130 of future value at the end of 2 years? • To answer we need to make a Net Present Value calculation

Net Present Value (NPV) • Given an interest rate of 10% what investment now will give a future value of £ 130 in 2 years time? ? invested now is worth ? *(1+0. 1) in 1 years time ? *(1+0. 1) becomes worth ? *(1+0. 1) in 2 years time Hence ? *(1+0. 1) = £ 130 ? = £ 107. 44 ©A. Ward 2002

Net Present Value (NPV) • In General • The Net Present Value of a return of £P in n years time with a prevailing interest rate of r% is given by: • Solve by spreadsheet or Discount Tables • Note this ignores future inflation rates. The model allows for varying interest rates per year. ©A. Ward 2002

Discount Factors ©A. Ward 2002

Net Present Value of a Cash Stream To handle a regular or periodic cash stream (in or out): ©A. Ward 2002 • Determine the periodic cash flow • Convert each cash flow to the net present value • Sum all present values to give Net Present Value of Stream

NPV Example ©A. Ward 2002

NPV Example ©A. Ward 2002

Sensitivity Analysis ©A. Ward 2002 • Capital Expenditure Proposals involve assumptions • Each Assumption can be tested • The sensitivity of the IRR or NPV can be determined for each assumption

Sensitivity Analysis - Example Consider a +/-10% change in initial cost of project ©A. Ward 2002

Sensitivity Analysis - Example Consider the effect of a year delay in sales Or 1 year delay in entire project ©A. Ward 2002

Sensitivity Analysis - Example Consider interest rate changes ©A. Ward 2002