Investment appraisal and NPV analysis
| by Peter Atrill 02 Mar 2004 Diploma in Financial Management Relevant to Module B |
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The net present value method
Investment decisions are very important to a business. They tend to involve large sums of money and their impact on the survival and prosperity of the business can be profound.
Once an investment decision has been made, and the funds committed, it is often difficult to abandon the project without significant losses being incurred.
It is therefore important that investment proposals are properly evaluated before a final decision is made. In practice, there are four major methods of evaluating investment proposals:
- Accounting rate of return (ARR)
- Payback period (PP)
- Net present value (NPV) method
- Internal rate of return (IRR).
The first two methods are the traditional methods of appraising investments and have been around for many years. The NPV method is a more recent development. This method discounts the future cash flows associated with the investment project using the cost of capital as the appropriate discount rate. The decision rule is that if the net present value of the discounted cash flows is positive, we should accept the project.
It is important to be aware of the advantages of this method over the ARR and PP methods. The most important advantages of the NPV method are that it:
- takes account of the time value of money, by discounting the cash flows arising in the future
- takes account of all relevant cash flows
- provides a clear decision rule concerning acceptance/rejection of a project
- is consistent with the objective of maximising shareholder wealth, which is assumed to be the primary objective of a business.
The IRR method is the last method listed above and is similar to the NPV method. It is based on the principle of discounting future cash flows and will normally give the same accept/reject decisions and will rank investment projects in the same way as the NPV method. However, the IRR method has difficulty in handling unconventional cash flows and does not address the issue of wealth maximisation as well as the NPV method. Thus, from a theoretical viewpoint, the IRR method is inferior to the NPV method. However, it seems that managers prefer the IRR method to the NPV method. This is perhaps because it provides an answer that is expressed as a percentage figure, which is easier to understand than present value pounds.
Some practical issues
From the above we can see that, if the objective of the business is to maximise the wealth of its shareholders, the NPV method is theoretically the best method to use. The general principles of the NPV method are fairly straightforward. However, the practical application of this method can cause problems. Thus, when dealing with questions relating to this method, the following points should be borne in mind.
- Relevant costs
Only future costs that vary with the decision should be included in the analysis. This means that past costs and committed costs should be ignored because they cannot vary with future decisions concerning the investment. - Opportunity costs
Opportunity costs do not result in cash movements. Nevertheless, they should be taken into account as they represent real benefits foregone. - Taxation
Investors are concerned with the after-tax benefits from their investment. This means that, where taxation information is provided in a question, it must be taken into account. The after-tax cash flows from an investment should be discounted using the after-tax cost of capital. - Cash flows
In NPV analysis, it is cash flows rather than profit flows that are used because it is the former that gives a business command over resources. In some cases however, a question may provide information concerning future profits rather than future cash flows. When this occurs, it is necessary to convert the profit flows into cash flows, which can be done by adding back any non-cash items appearing in the profit and loss account. The most common example of a non-cash item is depreciation. - Working capital
Where profit flows are converted into cash flows, some adjustment may be necessary in respect of the investment in working capital over the period of the project. Any addition to working capital will be treated as a cash outflow and any release of working capital will be treated as a cash inflow in the period in which it occurs. - Interest payments
Interest payments are not deducted in arriving at the relevant cash flows for the investment project. The cost of financing is taken into account in the discount rate (which is based on the cost of capital) and so should not be taken into account again when deriving the relevant cash flows.
It is worth mentioning that the above points are also relevant to the application of the IRR method, although this is not the subject of this article. Having now gone through some of the practical points to watch out for in an NPV question, let us go through a question that appeared in the December 2003 Financial Strategy examination paper.
Illustrative question
Galena plc owns an open-cast coal mine in Wales that was purchased from the UK government in 1992. In recent years, the performance of the mine has been badly affected by a decline in demand for coal and also by cheap imports. Mining engineers employed by the company believe that the mine could be operated for another four years before coal supplies finally run out. If the mine is operated during this period, the following financial results are expected:
The following additional information is available:
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- The machinery and equipment at the mine cost £18.0 million and have a written down value of £8.0 million. The machinery and equipment will be sold at the end of the four-year period for an estimated £2.0 million.
- A depreciation charge for the machinery and equipment of £1.5 million per year and an amortisation charge for depletion of the mine of £4.0 million per year are included in the above calculations.
- The working capital tied up in the mine is £3.6 million and this can be liquidated immediately the company discontinues its operations.
- Redundancy payments to employees will amount to £2.2 million if the company operates the mine for a further four years and employees are released at the end of this period.
- The company has agreed with the UK government to fill in the mine and build a community centre in the area in five years time. This is estimated to cost £2.5 million and this commitment will not be affected by any decisions concerning the future of the mine.
The company has been approached by a miners’ co-operative, consisting of employees of the mine. The co-operative has offered to lease the mine for the remaining four years of its life at a lease rental of £6.0 million per year, payable at the end of each year. The co-operative has also offered to buy the existing machinery and equipment from the company for £5.0 million immediately if a lease agreement can be reached.
The co-operative has also offered to make a contribution of £1.5 million towards the cost of building the community centre in five years’ time. No other parties have declared an interest in taking over the mining operations.
If the company agrees to lease the mine, and thereby discontinue operations, it will have to make redundancy payments of £3.4 million immediately.
- Galena plc has a cost of capital of 10 per cent.
- Ignore taxation.
Required:
- Calculate the incremental cash flows arising from a decision to continue operations for a further four years rather than to lease the mine to the miners’ co-operative.
- Calculate the net present value of continuing operations for a further four years rather than leasing the mine to the miners’ co-operative.
This question can be answered as follows:
(a) Incremental cash flows
| Year | 0 £m |
1 £m |
2 £m |
3 £m |
4 £m |
5 £m |
| Operating profit (loss) | 54.0 | (46.0) | (15.0) | 22.0 | ||
| Add Depreciation and amortisation | 5.5 | 5.5 | 5.5 | 5.5 | ||
| Operating cash flows (Note 1) | 59.5 | (40.5) | (9.5) | 27.5 | ||
| Sale of machinery and equipment (Note 2) | (5.0) | 2.0 | ||||
| Redundancy payments (Note 3) | 3.4 | (2.2) | ||||
| Lease rental and community centre contribution (Note 4) | (6.0) | (6.0) | (6.0) | (6.0) | (1.5) | |
| Working capital (Note 5) | (3.6) | 3.6 | ||||
| (5.2) | 53.5 | (46.5) | (15.5) | 24.9 | (1.5) | |
| (b) Discount rate 10% | 1.00 | 0.91 | 0.83 | 0.75 | 0.68 | 0.62 |
| Present value | (5.20) | 48.69 | (38.60) | (11.63) | 16.93 | (0.93) |
| Net present value | 9.26 |
Notes to the solution
- The operating cash flows for each year are derived by adding the depreciation and amortisation charges for the year back to the operating profit. Interest payments have not been deducted in arriving at the operating cash flows for the reasons mentioned earlier.
- By continuing operations, the business foregoes the opportunity to sell machinery and equipment immediately. The amount foregone of £5.0m appears as an immediate outflow. When the machinery and equipment is eventually sold for £2.0m in Year 4, the cash received will be treated as an inflow.
- By continuing operations, the business avoids paying redundancy payments of £3.4m and this appears as an immediate benefit (inflow). When redundancy payments of £2.2m are eventually paid in Year 4, they appear as an outflow.
- By continuing operations, the business foregoes the opportunity to receive a lease rental (£6.0m) and community centre contribution (£1.5m). The amounts foregone appear as outflows in the relevant years.
- By continuing operations, the business foregoes the opportunity to release working capital immediately. This amount of £3.6m appears as an outflow in Year 0. When the working capital is finally released in Year 4, it appears as a cash inflow.
- The cost of building the community centre has not been included in the above calculations because it is a committed cost. That is, it must be paid whichever choice is made.
- The original cost of the machinery and equipment (£18.0m) is a past cost, which has been ignored in the above calculations for the reasons mentioned earlier. Similarly, the written down value of £8.0m, which is the original cost less accumulated depreciation, has been ignored.
The NPV of the project is positive and so, assuming the estimates are correct, acceptance of the project will enhance shareholder wealth.
Summary
To conclude, where the objective of a business is to maximise the wealth of its shareholders, the NPV method is the appropriate method to use when appraising investment opportunities.
Peter Atrill is examiner for Module B of the Diploma in Financial Management