Dr Dionysios PolemisDepartment of Maritime Studies University of Piraeus

Investment Appraisal

Investment Appraisal

TEXT BOOK: Finance for Executives, Hawawini & Viallet

Today’s agenda Introduction

Investor’s Questions

Important Points

Consumption Vs Investment

Approaches to assess the efficiency of an investment

Difficulties in the evaluation

Basic Terminologies

Data- Cash-flows

Only cash matters

Methods of analysis-Payback, NPV, IRR

ROE & ROIC

Q&A

What is always in the mind of a Manager;

• To identify the best method of increasing the profitability of his company

• To minimise the risks associated with the investments implemented by his company

Conclusion

• For the survival and growth of any company, important decisions must be made for the long term investment strategy that will have to be implemented

Questions regarding the investor

• The project will be profitable? If yes, when?

• Should we invest in another project?

• Should we support existing investment projects or should we stop them to cut losses

For any given project

• How many will be the positive cash flows and how many the negative ones.

• What is the impact of any given investment and which amount is considered as the investment’s celling.

The first rule of finance

“ A Dollar today worth's more than a Dollar tomorrow”

Important fact that need to be considered in your financial analysis

• Be extremely careful over the number you use in your analysis to compare different investment projects

• Always consider the time value of money in your analysis

3 Important Points – (1)

• The credit worthiness of your analysis is as good as the numbers /information you incorporated

• It is almost impossible to forecast with high precision future cash inflows

• All forecasts should be dealt with extreme care

3 Important Points – (2)

• The financial analysis is only one part of the procedure in the decision making process of any investment• There aren’t any unmistaken financial tools to assist

you in the investment decision process• The results of any analysis should not be the only

criteria for accepting or rejecting a project.

3 Important Points – (3)

• When you present your financial analysis keep always in mind that some members of the board/ audience may not have knowledge of finance • The outcomes of the analysis should be clearly stated• The presentation of the results should be simple and

easy to comprehend.

Consumption Vs Investment

• Consumption• You pay something today and you get an immediate

return benefit

• The amount spend cannot be refunded

• You can immediately compare cost –benefit

• Subjective assessment criteria

• The consequences of your choice are short term

Consumption Vs Investment

• Investment

• You commit a portion of money today with the perception of future benefit (economic or else)

• The is the possibility of a gradual recall of your initial investment

• Luck of imminent comparison between cost-benefit • Objective assessment criteria over the outcome of the

investment (economical or else) • The consequences of investment are long term

Investment Consequences

• Direct economic consequences to the investor• Profits or Losses• Recall or loss of an investment• Indirect economic consequences (economic

environment)• Contribution to the growth of a country’s economy• Increase in the employment rates• Increase in the export – increase/ decrease in imports• Effects on other production sectors

Approaches to assess the efficiency of an investment

• Direct economic impacts• The investor is interested for the assessment• Financial analysis is applied• The evaluation criteria take into account the market prices

• Direct and indirect economic impacts • The evaluation affects the state economy • Applies Economic Cost- benefit• Taken into account shadow prices • They do not consider transfer payments

Approaches to assess the efficiency of an investment

• Environmental and social impacts

• The evaluation refers to the whole society

• Apply social cost –benefit

• The evaluation criteria take into account market prices and additional external economies (externalities)

The difficulties in the evaluation criteria of an investment

• Forecast of future conditions• Data of necessary inputs (availability of freights, vessels)• The market of the produced output (demand, prices,

competition)• Wider economic environment (inflation, interest rates)

• Comparison of revenues –expenses occurring at different times• During the initial and implementation phase of the investment• During the operation stage• Inflation

Basic Terminology

• Capital:• The monetary units which have the capacity to produce

other goods or monetary units

• Interest:• The return earned on an investment

• Interest rate:• The fee charged by a lender to a borrower for the use of

borrowed money, usually expressed as an annual percentage of the principal

Data – Cash Flow

• Positive cashflow is a measure of incoming money• E.g Freights, sales, interests etc

• Negative cashflows is the measure of outgoing money• E.g Acquisitions, fleet maintenance costs, salaries, taxes

Table of Cash flows

• The economic analysis aims to accept or reject of an investment project.• The basic tool is the table of cashflows arising from the

project

• Cash flow is the difference of two quantities: the cash inflow and the cash outflow

• Cashflow refers to specific operating period, usually annual.

Only money counts

•Provide the initial cash required to finance the proposal

Investors•The proposal generates future cash that return to

Business Proposal

•New Business Proposal

Investors

Methods of Analysis

• There are several methods of analysis

• The most famous are 3: “Payback”, “Rate of Return”, “Discounted Cash Flows”

• All methods mentioned are based on the net income on investment (project)

Payback Method

• It gives more weight to liquidity rather than profitability

• The method is related to the time it takes an investment program to repay the amount spent on it with the revenue generated .

Example

• Suppose you bought a used vessel for $ 3 million dollars

• In our plans we expect that taking into account all operating and administrative expenses the vessel will bring $ 1 million dollars per year for 5 years and then sell it for “scrap” for ½ of a million dollars

Example

Year Net cash Flow Cumulative Cash Flow

0 (3,000,000) (3,000,000)

1 1,000,000 (2,000,000)

2 1,000,000 (1,000,000)

3 1,000,000 0

4 1,000,000 1,000,000

5 1,500,000 2,500,000

Different Cashflows– Same method

Year

Net cash Flow

- case II

Cumulative

Cash Flow

Net cash Flow

- case III

Cumulative

Cash Flow

0 (3,000,000) (3,000,000) (3,000,000) (3,000,000)

1 250000 (2,750,000) 1,000,000 (2,000,000)

2 750000 (2,000,000) 1,000,000 (1,000,000)

3 2,000,000 0 1,000,000 0

4 1,000,000 1,000,000 2,000,000 2,000,000

5 1,500,000 2,500,000 2,000,000 4,000,000

Advantages Vs Disadvantages

• Disadvantages:• It cannot take into account the cash flows after the

payback period

• Does not consider time value of money

• Advantage:• It shows if the capital invested can be repaid until the

end of the transaction.

Net Present Value

• The NPV depicts the contribution of an investment in the business value

• The NPV of an investment equals the present value of expected future annual inflows discounted at a rate that reflects the risk of expected cashflows

Net Present Value

• The interest rate used to discount expected cash flows equals the yield offered by comparable alternative investments – Required Rate of Return by the company

Net Present Value

• The NPV can be computed from the following formula :

NPV = Σ t=0 * [CFt/(1+k)^t]

CFt: The annual additional cash flow after taxes for the year t and t = 0,1,2… h (cash flow can take positive or negative value), k = required performance

NPV: Criteria of acceptance or rejection

• If the NPV is greater than or equal to 0, the proposal is accepted.

• If NPV = 0, then the cash flows of the project is enough to repay the initial cost and pay the required return that shareholders expect (stable share price).

• If NPV> 0, then the cash flow yield provide an additional cash flow more than the investment’s requirement that is enjoyed by the shareholders

• If NPV< 0 the then project is rejected

NPV : Advantages

• The NPV uses cash flows rather than net profits(cash flow + depreciation) include depreciation on capita funding resources. Thus the NPV takes into account the actual time at which any benefits are derived from the investment.

NPV : Advantages II

• NPV fully recognises the time value of money

• Acceptance of an investment with positive NPV increases the value of the company (increase of the company’s share price)

NPV: Disadvantages

• The method requires accurate prediction of future cashflows ( as we move away from T0 this becomes more and more difficult to estimate accurately)

• The method assumes that the discount rate is fixed for the duration of the investment program.• Unrealistic when the program takes several years

NPV: Example

• Company A is planning to invest on a tanker. The initial cost of investment is $ 100 millions. It is estimated that the program will generate the following future cashflows after taxes

• Year 1 = 50 mil., Year 2 = 22.5 mil., Year 3 = 90 mil., Year 4 = 95.mil.,

• = Discount rate 10%

NPV: Example - Solution

• NPV = [ -100,000,000] + [50,000,000/(1+0.1)] + [22,500,000/(1+0.1)^2] + [90,000,000/(1+0.1)^3] + [95,000,000/(1+0.1)^4 = 96,554,197

• Since the NPV equals 96,554,197 >0, the investment proposal is accepted

Η μέθοδος του Εσωτερικού Βαθμού Απόδοσης (Internal Rate of Return – IRR)

• The Internal Rate of Return is the discount rate that resets the Net Present Value of the program

Internal Rate of Return – IRR

• Computed:

CF0 = Σ [CFt /(1+ΙRR)^t] ή Σ [CFt /(1+ΙRR)^t]= 0

• CFt = The future net cash inflow at time t.

• ΙRR = Internal Rate of Return

Criteria of Accepting or Rejecting a project

• If the IRR is greater than or equal to the required performance, the proposal is accepted

• Otherwise the proposal is rejected.• When the IRR of an investment exceeds the initial

cost of the investment then the excess funds are given to the shareholders of the company.

IRR - Advantages

• It utilises cash flows and at the same time recognises the time value of money

• It is popular method because it is easier to explain the outcome in comparison to the NPV

• To the extent that the requirement is a rough estimate, the IRR is likely to be a more satisfactory method of assessing a project

• Allows evaluation of the performance of an investment relative to the risk assumed by it.

IRR - Disadvantages

• It requires as the NPV accurate forecasts of future cash flows

• It assumes that future cash flows are reinvested at a rate equal to the internal rate of return

• The method can deliver multiple Internal Rates of Return

Internal Rate of Return – IRRExample

• Company A is planning to invest on a tanker. The initial cost of investment is $ 100 millions. It is estimated that the program will generate the following future cashflowsafter taxes

• Year 1 = 50 mil., Year 2 = 22.5 mil., Year 3 = 90 mil., Year 4 = 95.mil.,

• Discount rate 10%

Internal Rate of Return – IRRSolution

- 100,000,000 +[50,000,000/(1+ΙRR)] + [22,500,00/(1+IRR)^2] + [90,000,000/(1+IRR)^3] + [95,000,000/(1+IRR)^4 = 0

- IRR = 0.4268 or 42.68%

IRR - Example

• Company A is planning to invest on a tanker. The initial cost of investment is $ 100 millions. It is estimated that the program will generate the following future cashflows after taxes

• Year 1 = 20 mil., Year 2 = 30 mil., Year 3 = 40 mil., Year 4 = 30 mil., Year 5 = 10 mil.

• Investors wish to receive 10% on their investment

IRR- Example (solution)

• Αν ΙRR = 10% τότε

PV=-100,000,000 + [20,000,000/(1+0,1)] + [30,000,000/ (1+0.1)^2] + [40,000,000/(1+0.1)^3] + [30,000,000/(1+0.1)^4] + [10,000,000/(1+0.1)^5]

PV= - 272,584.46

Since -272,584.46 ˂ 0 we reduce the IRR

IRR- Example (solution)

• If ΙRR = 9% then

PV=-100,000,000 + [20,000,000/(1+0,09)] + [30,000,000/ (1+0.09)^2] + [40,000,000/(1+0.09)^3] + [30,000,000/(1+0.09)^4] + [10,000,000/(1+0.09)^5]

PV= 2,238,433.05

since 2,238,433.05 ˃ 0 the correct IRR is between 10% and 9%

IRR- Example (solution- last three steps)

1. [2,238,433,05 - (- 272,584,46)] = 2,511,017,51

2. 2,238,433,05/ 2,511,017,51= 0.8914

3. Then IRR is equal to 9 + 0.8914 = 9.89%

Corporations most commonly utilise to finance their investment a combination of equity and debt capital.

Shareholders and debt holders require a return on their investment

When a project is financed by equity and debt capital, the cost of capital is no longer equal to the cost of capital.

Investment’s Cost of Capital

Assume that a project will be financed with a 50% equity and 50% with debt. In addition suppose that the project estimated after-tax cost of debt is 6% and the cost of equity s 10%. What is the Weighted Average Cost of Capital?

WACC = (6% * 50%) + (10% * 50%)

= 3% + 5%

= 8%

Note: In merchant shipping we do not consider in the WACC formula the corporate tax. Otherwise the formula used is the following:

WACC= (Equity% + Debt %)* (1-Tc)

Weighted Average Cost of Capital

Return of Equity & Return on Invested Capital

End of Session

Thank you for your attention!

Q&A