Now, that we know how to calculate the cost of capital, let us dive into the investment assessment methods.
In the second post in this series, I have mentioned that value has many different facets. An innovative product, intellectual property, market power, access to regulatory approval which are difficult to get – all can be valuable if someone is willing to pay for that. Also, we talked about how value can be created in stages.
Traditional capital investment assessment is based on the assumption that all capital investments will result in cash-flows which are fairly predictable. Entrepreneurs often face complex projects where either the outcome is not cashflows or cash flow (or income) can after a few stages after the implementation of the current project. Consider the example of a CSR project which has obviously reputational benefit and may increase long term value of the company but does not result in any cash flow. Consider another example of a research and development project to develop a new intellectual property (IP). The IP will not readily generate cashflow unless it is commercialised.
Traditional investment assessment methods are not capable of handling such complexities. We will divide this discussion into two sections. The first section (this post) will introduce the traditional methods and the second section (next post) will introduce non-traditional methods which can deal with the problems mentioned above.
We can further classify the traditional methods into non-discounting and discounting based methods.
1. Non – Discounting Methods
a. Accounting Rate of Return (ARR)
= (Average Annual Income) / (Investment)
There are various versions of this method. We can consider the average total return for the total investment or calculate returns from the book value of the investment at the beginning of the years and calculate the average of them or calculate the average income and divide it by the average book value of the investment.
The basic idea is to calculate on an average, how much income the investment generates.
b. Payback Period
= (Capital Invested) / (Average Annual after-tax cash-flow)
Payback period tells us how long it takes to get the invested money back.
2. Discounting Methods
The problem with non-discounting methods is that they do not consider the time value of money. Also, there is no way to incorporate the return expectations in the decision-making process.
Discounting methods try to solve these issues.
a. Net Present Value (NPV)
NPV discounts the future cash-flows with the weighted average cost of capital (WACC) and nets it with the initial investment. A positive NPV indicates that a project is economically feasible. We have discussed the calculation of the WACC in the last post in this series.
Many projects are often an extension of other projects. For example, a manufacturing company is setting up a machining facility and trying to choose between machines of different capacities – one light and another of heavy capacity. The heavy capacity (and expensive) machine will increase the capacity but the company is not sure how much of the extra capacity can be used. For this kind of cases, we can calculate the NPV of the excess earnings generated by the heavy capacity machine over the light capacity machine. This is called the Excess Earnings method.
Also, the company may want to evaluate whether the machine is at all required. In this case, the company can calculate NPV without the machine and with the machine and compare them. This is called 'with or without' analysis.
b. Internal Rate of Return (IRR)
IRR is the discount rate at which the discounted future cash-flows equate to the initial investment. An investment proposal is accepted if the IRR is higher than the WACC and rejected if it is lower than that.
Also, projects can be compared based on IRR.
The IRR method assumes that the future cash flows will be reinvested back at the same rate as the IRR – this is a stretch.
Also, IRR is very sensitive to the pattern of cash-flows. This makes IRR of limited ability to compare different projects with different cash-flow patterns.
c. Modified Internal Rate of Return (MIRR)
MIRR tries to solve the above-mentioned issues with IRR. In this method, the future cash-flows are brought to the terminal value using an appropriate discount rate (generally WACC). So, we are only dealing with two values – initial investment and the terminal value which is the aggregate of all the future cash-flows. Then we can simply calculate the rate of return based on these two figures and the time period to the terminal date.
d. Profitability Index (PI)
= (Sum of the present value of all cash inflows) / ((Sum of the present value of all cash outflows)
A project is accepted when the PI is higher than one and rejected if it is lower than one. Also, we can compare projects by comparing PI values.
e. Discounted Payback Period
As mentioned before, the Payback Period method fails to consider the time value of money. The discounted payback period method adjusts the future cash-flows by the appropriate discounting rate and then calculates the payback period.
To be continued......