Investment Appraisal for Managers PDF
Preview Investment Appraisal for Managers
Investment Appraisal for Managers Graham Mott Investment Appraisal for Managers First published 1982 by The Macmillan Press Ltd by arrangement with Pan Books Ltd © Graham Mott 1982 Softcover reprint of the hardcover 1st edition 1982 ISBN 978-1-349-06496-0 ISBN 978-1-349-06494-6 (eBook) DOI 10.1007/978-1-349-06494-6 to Valerie and Kay Contents I What is investment appraisal? 7 2 Which appraisal method should I use? I6 3 What are cash flows? 3 5 4 Is tax a cash flow? 49 5 How certain can we be about the future? 65 6 What about inflation? 8I 7 How much should a project earn? 96 8 What is life cycle costing? I09 9 Conclusions I 2 I IO Some case studies I25 Appendix A Table of present value of £I I44 B Cumulative table of present value of £I per annum I46 C Glossary of terms I 50 Index I55 What is investment 1 appraisal? Investment appraisal is concerned with managers' decisions about whether, when and how to spend money on their firms' projects. Such decisions are important ones for the companies involved because often large sums of money are committed in an irreversible decision, with no certain knowledge of the size of future benefits. Suppose a printing firm is considering buying a binding machine for £10,000 which will reduce labour costs on this activity by £3,000 every year for each of the five years the machine is expected to last. What the management of this firm have to consider - and this is no easy task - is whether a return of £3,000 every year for five years justifies the initial investment of £Io,ooo. The essence of all investment appraisals is to measure the worthwhileness of proposals to spend money, by comparing the benefits with the costs. If this measurement is done badly, it can hamper a firm's growth and employment pros pects for years to come, and may lead to an inability to attract new investors. Financial institutions and individuals provide firms with money in the expectation of a reasonable rate of return. If a firm invests that money in projects which do not yield a reasonable return then investors will be wary of that company in the future. We measure the worthwhileness of investment proposals by building simple financial models of the expected events. Using the binding machine example above we can set out the expected events as cash inflows or outflows for each year of the machine's life, as in Figure I. I. These cash flows start at Year o which is the beginning of the first year when the project is initiated. The two main aims of this book are to identify the various items to include in the yearly cash flows and to examine the 7 Figure I. I Financial model of the binding machine project £ Year o - 10,000 Year 1 + 3,000 Year 2 + 3,000 Year 3 + 3,000 Year 4 + 3,000 Year 5 + 3,000 Total profit + £s,ooo available techniques which say whether the investment is worthwhile or not. Subsequent chapters discuss the tech niques in depth and show the build-up of the yearly cash flows allowing for taxation, uncertainty and inflation. Managers are involved in money-spending decisions either as initiators of projects, or as top management putting the final seal of approval on other managers' plans. For example, functional managers may identify profitable op portunities and direct their staff to investigate them more fully. Other staff may approach a functional manager with their own ideas for new investment. An awareness of the factors influencing the profitability of such investments must help managers channel the firm's resources down more profitable paths. In many firms it is left to the accountant to pronounce a verdict on the viability of a proposed investment project. This presupposes not only that he is trained in appraisal techniques (which he usually is, of course) but also that he fully understands the marketing, production and human aspects of such proposals. Many arguments favour man agers from the whole range of business functions being involved in decision making. If you are a manager, you should be aware of the factors that are relevant to a project's profitability. You need to be able to talk the same language as financial managers and accountants. Most of all, you must be able to identify and generate potentially profitable investments for your firms. 8 Environmental aspects When appraising projects, managers have to look at both the internal and external factors affected by their decision. If the proposal is, for example, a diversification away from existing activities, we must first see if it fits the corporate strategy laid down by the board of directors, or whether such investment warrants a change in that strategy. Man agers today are much more aware of their social responsi bility to employees. How does the proposal under review affect present employment and future promotion prospects? Looking outside the firm, managers should be aware of their responsibilities to the local community in terms of the environment, pollution and employment opportunities. There are also the 'knock-on' effects of services to be pro vided locally to the firm or to its employees. Firms also have responsibilities to the nation. They contribute taxes to help finance centrally funded services and their exports or import substitutes help pay for our importation of essential foodstuffs and raw materials. Last but not least we must consider the needs of the customer, without whom the firm would no longer be in business. All of these internal and external factors may influence investment decisions but these are outside the scope of this book, which primarily concentrates on the financial aspects of the decision. This is not to suggest that the financial factors are paramount, but that this book intends that man agers should make investment decisions in the full know ledge of the likely financial consequences, not in ignorance of them. We now need to look at the variety of situations which demand the manager's attention and require him to make good decisions. Types of investment situation There are a number of basic situations where an appraisal method assists a manager to make a sound decision. These include the following: 1 Expansion - assessing the worthwhileness of expanding existing product lines requiring additional investment in buildings, plant, stocks, debtors, etc. 9 2 New product/diversification - assessing the viability of the more risky investment in totally new products. 3 Cost saving - assessing the profitability of a cost saving scheme - for example, when an investment in a new machine automates an existing manual process. 4 Replacement - deciding whether and when to replace an old machine with a new one to save operating costs or reduce wastage. 5 Alternative choice - deciding between alternative invest ments to achieve the same ends- for example, choosing between two or more machines with different financial characteristics. 6 Financing - comparing the cost of purchasing an asset outright with the alternative cost of leasing. All the above investment situations have the same common approach. In each case we must decide whether the benefits we get from the initial investment are sufficient to justify the original capital outlay. The next chapter examines the available techniques used to decide whether an investment is worthwhile. Chapters 3 and 4 explain how the yearly cash flows are built up in these investment situations and how the effects of taxation can be incorporated. There may be some investment situations where no ben efits are quantifiable in money terms. For example, the government may require firms to invest in fire detection and alarm systems in all their premises. In this case firms have no choice, and although there will be benefits in em ployee welfare these are not readily quantifiable in cash terms. Even in this kind of situation an appraisal technique could be used to help us make the choice between compet ing systems which have different financial characteristics. In the case of the fire detection and alarm system one supplier's equipment may have a higher capital cost but a low maintenance cost over a long life. An alternative sup plier's equipment may have a low capital cost but high maintenance costs over a short life. We need to formalize 10
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