Evaluating financial feasibility of long term Investment opportunities

What are 'Long-Term Investments' A long-term investment is an account on the asset side of a company's balance sheet that represents the company's investments, including property plant and equipment, that it intends to hold for more than a year. The long-term investment account differs largely from the short-term investment account in that the short-term investments will most likely be sold, whereas the long-term investments may never be sold. Winfield Academy of Business and Finance 11/26/2020 2

Capitalizing growth potential (Strategic options) § Organic growth § Inorganic growth Main features § High risk § High capital investment Winfield Academy of Business and Finance 11/26/2020 3

Evaluating strategic options Johnson's and Scholes 3 strategic test § Financial feasibility § Suitability (Organization resources and capability § Acceptability (Sustainability ) Winfield Academy of Business and Finance 11/26/2020 4

Evaluating financial feasibility of strategic options Investment Appraisal Methods Discounted Cash Flow Methods Net Present Value (NPV) Internal Rate of Return (IRR) Non-Discounted Cash Flow Methods Payback Method

Discounted Cash Flow Methods NPV - the sum of discounted future cash flows less the initial cost IRR - the discount rate where NPV = 0

Compounding interest rate FV= PV (1+R)N FV=Future value PV=Present value R=Rate of return N=Number of years

Example 1. If you invest 100, 000 for 5 years at a rate of 7%, what would be the value of the investment after 5 years. 2. If you invest 500, 000 for 5 years at a rate of 9%, what would be the value of the investment after 3 years 3. If you invest 400, 000 for 5 years at a rate of 10%, what would be the value of the investment after 5 years. Interest will be compounded on a quarter basis. 4. If you need to have 500, 000 value of investment in after 5 years at rate of 8%, how much will you invest today? 5. If you need to have $ 1 value of investment in after 5 years at rate of 8%, how much will you invest today?

Net Present Value (NPV) NPV = C 2 C 1 + + C 3 (1 + r)1 (1 + r)2 (1 + r)3 Discounted cash flows C 1, C 2, C 3 = the project cash flows, r = discount rate (related to risk of the project) C 0 = initial cost - C 0 Initial Cost

Investment Decisions The board of directors of Magoo plc. is considering investing in a new machine that is expected to have a three year life and will cost £ 100, 000. The machine is used to produce a good that is expected to have the following cash flows over the three years of the machine’s life - Year 1 = £ 30, 000; Year 2 = £ 50, 000; Year 3 = £ 40, 000. The firm expects to obtain a 12% return on a project of similar risk Should it purchase the machine?

Fundamental Rule of Finance/Financial Economics A capital investment decision is only worthwhile if it adds value. Thus, invest only in projects with a positive net present value

INTERNAL RATE OF RETURN (IRR) Also based on Discounted Cash Flow, but calculates the discount rate that will give a Net Present Value of zero. This also represents the return that the project is giving on the original investment, expressed in DCF terms. The simplest way is to use trial and error - trying different rates until the correct rate is found. But this is laborious. There is a formula, using linear interpolation. Projects should be accepted if their IRR is greater than the cost of capital or hurdle rate.

IRR – Interpolation method o o Where: L is the lowest discount rate H is the higher discount rate NL is the NPV of the lower rate NH is the NPV of the higher rate

NPV and IRR Gullane plc. are considering investing in a new machine that will cost £ 1 million. They estimate the machine will lead to an increase cash flow for the next three years of £ 500, 000 in year 1, £ 600, 000 in year 2, and £ 400, 000 in year 3. Given that Gullane plc. determine that the cost of capital is 10%, calculate the Net Present Value of the machine and recommend whether to ahead with the investment or not Calculate the Internal Rate of Return of the machine

Example of NPV Year PV PV 1 500, 000/1. 1 = 454, 545. 45 2 600, 000/(1. 1)2 = 495, 867. 77 3 400, 000/(1. 1)3 = 300, 525. 92 1, 250, 939. 14 NPV = PV - Cost = 1, 250, 939 - 1 m = £ 250, 939 NPV is positive, therefore go ahead with investment

Example of IRR - using r = 20% Year PV PV 1 500, 000/1. 2 = 416, 666. 7 2 600, 000/(1. 2)2 = 416, 666. 7 3 400, 000/(1. 2)3 = 231, 481. 5 1, 064, 815 NPV = PV - Cost = 1, 064, 815 - 1 m = £ 64, 815

Example of IRR - using r = 25% Year PV PV 1 500, 000/1. 25 = 400, 000 2 600, 000/(1. 25)2 = 384, 000 3 400, 000/(1. 25)3 = 204, 800 988, 880 NPV = PV - Cost = 988, 880 - 1 m = (£ 11, 200)

IRR - cont. IRR = 20 + 64, 815 x (25 - 20) = 24. 263% 76, 015 To check result, calculate NPV with r = 24. 263% and ensure result has NPV = zero

Internal Rate of Return Decision Rules If k > r reject. If the opportunity cost of capital (k) is greater than the internal rate of return (r) on a project then the investor is better served by not going ahead with the project and using the money to the best alternative use If k < r accept. Here, the project under consideration produces the same or higher yield than investment elsewhere for a similar risk level

Non-discounted methods: Payback Period Payback period - the length of time it takes to payback the initial investment Payback Rule - choose the investment that pays back the initial investment the quickest

Example of Payback Period and ARR Year Cash Flow for Project Y (in HK$) Cash Flow for Project Z (in HK$) 0 -200, 000 -150, 000 100, 000 2 100, 000 50, 000 3 150, 000 25, 000

Example - cont. Payback Period Project Y: 2. 33 years (2 years 4 months) Project Z: 2 years ARR Project Y: [(300000 -200000)/200000]x 100% = 50% Project Z: [(175000 -150000)/150000]x 100% = 16. 67% Payback Method choose project Z; ARR method choose project Y

Problems with Non-Discounted Cash Flow Methods Fails to take into account the time value of money and thus projects may lose value (money) despite apparently positive ARR. Payback period ignores cash flows beyond payback and thus less profitable projects may be chosen.

Student Activity Ashanti plc. , are considering an investment of 1. 8 m to enter in to the north east region of Sri Lanka. The capital investment is expected to have equal lives of 3 years and the cash flows for each year is given below: Any capital expenditure project is evaluated at corporate WACC as a hurdle rate. First year of the project is exempted from tax and 10% is applied after that. Investment Revenue Operational cost Year 0 1, 900, 000 Year 01 Year 02 Year 03 1, 000 300, 000 1, 400, 000 300, 000 2, 000 300, 000 Ashanthi plc has 10 million equity and 5 million debt. It has 10% pa interest payment commitment in its debt and shareholders require 14 % return on their investment. The corporation tax rate is 28%. You are required to evaluate the financial feasibility of the new expansion using NPV, IRR and the pay back period.